29 OTTOBRE 2014

Does law matter for economic development: the case of China

by Natalie Mrockova Doctoral researcher and lecturer Pembroke College – University of Oxford

Does law matter for economic development: the case of China* by Natalie Mrockova

Doctoral researcher and lecturer Pembroke College – University of Oxford

Abstract: Traditionally, law has been seen as particularly important for economic development, and variations in laws‟ quality across countries had been used to explain the cross-national disparities in economic performance. It has also been proposed that good laws can support a well-functioning banking and financial sector which in turn co-determine the overall direction and quality of the economic development. However, the importance and role of law in economic development has recently been doubted, with many pointing out the stark contrast between China‟s weak laws and spectacular economic performance over several decades. Although it is true that China‟s growth does not seem to endorse the general thesis that only strong law can support strong economic performance, I believe that China‟s seemingly contradictory example simply highlights the necessity to refine the theory and differentiate between transition economies on the one hand (e.g. BRICS) and market economies (e.g. US, UK) on the other, but it does not fundamentally undermine the importance of law for economic development. My argument is two-fold. Firstly, many commentators rely on a mistaken assumption about the initial and subsequent growth of China‟s economy, claiming it occurred entirely or almost entirely without the support of law. I will show this to be incorrect on both accounts. Second part of my argument focuses on the real utility of extra-legal substitutes, with particular focus on the later stages of the transition. I will argue that although Draft version of the paper to be presented at the international Conference BRICS in the spotlight, University of Parma 6th and 7th November 2014. *

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social norms and other extra-legal substitutes can support development up to a certain stage, sole reliance on such substitutes becomes an obstacle to further growth once the economy gets to a more advanced stage in transition. I will provide examples which show that China is already experiencing problems due to imperfect or even missing laws, and argue that remedying such inefficiencies and enabling further growth are only possible with stronger, better-enforced law. Parallels will be drawn with the development in Russia and the historical experience of the Central and Eastern European transition in 1990s. Keywords: China – role of institutions– economic development. List of contents: 1. Introduction. 2. Role of Law in Economic Development. 3. Why Law Still Matters – Even in China. 3.1. Role of law in China‟s development so far. 3.2. Extra-legal substitutes, law and economic development. 4. Conclusion.

1. Introduction. Traditionally, law has been seen as particularly important for economic and financial development, and variations in laws‟ quality across countries had been used to explain the cross-national disparities in economic performance. However, the importance and role of law in economic development has recently been doubted, with many pointing out the stark contrast between China‟s 1 weak laws and spectacular economic performance over several decades. Although it is true that China‟s growth does not seem to support the general thesis that only strong law can support strong economic performance, I believe that China‟s seemingly contradictory example simply highlights the necessity to refine the theory and differentiate between transition economies on the one hand (e.g. BRICS) and market economies (e.g. US, UK) on the other, but it does not fundamentally undermine the importance of law for economic development. My argument is two-fold. Firstly, many commentators rely on a mistaken assumption about the initial and subsequent2 growth of China‟s economy, claiming 1China

in the context of this article refers to the People‟s Republic of China which was established in 1949. 2 For the purposes of this paper, initial development phase started with Deng‟s economic reforms in 1978 and was superseded by the subsequent development phase after Deng‟s Southern Tour in 1992 (n.40)

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it occurred entirely or almost entirely without the support of law. I will show this to be incorrect on both accounts. Second part of my argument focuses on the real utility of extralegal substitutes, with particular focus on the later stages of the transition: while extra-legal substitutes play a significant role at early stages of economic development, they are partly superseded by formal law that supports the arms-length dealings which start appearing as the economy grows, transactions become more complex and economic actors interact with increasingly heterogeneous counterparties. In other words, although social norms and other extra-legal substitutes can support development up to a certain stage, sole reliance on such substitutes becomes an obstacle to further growth once the economy gets to a more advanced stage in transition. I will provide examples which show that China, currently at an advanced stage of the transition from relational to arms-length dealings, is already experiencing problems due to imperfect or even missing laws, and argue that remedying such inefficiencies and enabling further growth are only possible with more appropriately designed, stronger, and better-enforced law. Where appropriate, parallels will be drawn with the development in Russia and the historical transition in Central and Eastern Europe.

2. Role of Law in Economic Development. Linking law and development goes back to Weber who argued that rational legal order allows individuals to arrange their affairs with some predictability which he saw as crucial for economic development. 3 This idea started off the first wave of law and development movement in 1960s and 70s. The second wave, in 1990s, was then initiated by North and his idea that laws provide constraints on individuals‟ behaviour which helps create hospitable environment for cooperation in complex exchange through providing better incentives to interacting agents, which in turn leads to economic development and growth.4Weber‟s wave put more emphasis on the role of culture, while North‟s focused more on the role of institutions (i.e. rules), but both saw law as the central element for ensuring social and economic

development,

and

argued

that

law‟s

quality

determines

economic

performance. 5 Subsequent research also suggested that good laws can help establish and

M. WEBER in G. ROTH and C. WITTICH (eds.), Economy and Society, UCP, 1979 D. NORTH, Institutions, institutional change and economic performance, CUP, 1990, pp.34-36; D. NORTH Structure and Change in Economic History, Norton, 1981, p.4 5 For various subsequent studies see: D. ACEMOGLU, S. JOHNSON, and J. ROBINSON, Institutions as the fundamental cause of long-run economic growth, In P. AGHION and S. DURLAUF (eds.), Handbook of economic 3 4

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support a well-functioning banking and financial sector which in turn co-determine the overall direction and quality of the economic development.6 These views have had great influence on international development activities and policies, and have determined the nature of law reforms in developing countries across the globe. However, seeing China‟s magnificent growth over the last few decades which seemingly occurred without law‟s support, many started to doubt the importance and role of law in economic development.7Some question whether it is possible to apply Western developmentbased theory to arguably very different environment in China and other developing countries.8While Weber and North saw law as a tool for enforcement of private contracts constraining state and other individuals‟ ability to encroach on pre-agreed rights and duties (i.e. rule of law), law in China has seemingly served more as a tool to facilitate political governance by one ruler, previously the emperor and now the Communism Party (i.e. rule by law). Moreover, many argue that even the subsequent growth has relied on extra-legal substitutes, not law, contrary to what the law and development theory predicts,9 and so it is hardly surprising that some conclude that the theory is wrong and that law is dispensable for economic development.10 Nevertheless, there is ample evidence that law and economic development are correlated, 11 even if their causal relationship is still unclear.12Disagreement also exists about which rules

growth, Elsevier, 2005, pp.385–472. Elsevier ; R. LA PORTA, F. LOPEZ-de-SILANES, A. SHLEIFER and R. VISHNY, Law and finance, Journal of Political Economy, 1998, pp.1113–1155 6 R. LEVINE, The legal environment, banks, and long-run economic growth, Journal of Money, Credit, and Banking, 1998, pp.596–613; T. BECK, A. DEMIRGUC-KUNT and R. LEVINE, Law and finance: Why does legal origin matter?, Journal of Comparative Economics, 2003, pp.653–675 7 Y. YAO and L YUEH, Law, Finance, and Economic Growth in China: An Introduction, World Development, 2009, pp.753-762 at 753; C. XU, The Fundamental Institutions of China’s Reforms and Development, Journal of Economic Literature, 2011, pp.107-1151 at 1080 8 For a summary of arguments see T GINSBURG, Does Law Matter for Economic Development? Evidence From East Asia, Law & Society Review, 2000, pp.829-856 9 F. ALLEN, J. QIAN and M. QIAN, Law, finance, and economic growth in China, Journal of Financial Economics, 2005, pp.57-116: in particular 57-59 10 See e.g. ALLEN, QIAN and QIAN (n.10) 11 R BARRO, Economic growth in a cross section of countries, Quarterly Journal of Economics, 1991, pp.407-443; NORTH 1990 (n.5); R. PEERENBOOM, Law, Wealth and Power in China, in J GARRICK (ed.), Law, Wealth and Power in China: Commercial Law Reforms in Context, Routledge, 2011 12 A. CHANG and C CALBERON, Causality and feedback between institutional measures and economic growth, Economics and Politics, 2000, pp.69-81; R. RIGOBON and D. RODRIK, Rule of law, democracy, openness, and income, Economics of Transition, 2005

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are important, when, and how to structure the necessary reforms. 13Generally, therefore, it has been suggested that we either need more evidence in favour of the law and development theory, or the theory should be case aside.14Subscribing to neither suggestion, I will argue below that China‟s success story doesn‟t negate the importance of law in development per se, but that it simply highlights the need to refine the law and development theory to capture the lessons learnt from China‟s development. 3. Why Law Still Matters – Even in China. The oft-cited criticism of law and development theory, and the reason some identify as the key to why China seemingly refutes it, is the fact that it is based on Western development, and that China is simply different. But I propose that despite the variations in culture and environment, the theory‟s central thesis can still serve as a valid base for our understanding of law‟s role in economies‟ transition. Various theories of economic development have been proposed15 and although they differ in details, they have one thing in common: they deal with the transition from simple relational dealings (i.e. with people you know and share some sort of personal connection), to more complex, arms-length dealings (also called „market‟). 16 China has been undergoing such transition since the commencement of economic reforms in 1978 which started off the initial development phase, and has been growing particularly fast since 1992 which I identify as the starting point for subsequent development.17 In this article I will argue that, firstly, law had a role to play in China‟s initial as well as subsequent growth, despite the many suggestions to the contrary (see 3.1). And secondly, after outlining some of the mechanisms that support relational and arms-length dealings, I argue that the significance of law increases as the economy transitions toward the market. I propose that in light of China‟s experience the law and development theories need to be adapted to reflect different needs that the economy has as it transits from mostly relational to See e.g. D. RODRIK, The New Development Economics: We Shall Experiment, but How Shall We Learn?, JFK School of Government Working Paper, 2008 14 For an overview see GINSBURG (n.9) 15For a comprehensive analysis of the important components of these theories see E. HELPMAN, The Mystery of Economic Growth, HUP, 2009 16NB: It is not automatic that every state reaches the stage where arms-length dealings are possible. Some countries, like Russia, started pro-market reforms but then due to largely political reasons slipped back to relational dealings which are supported by mostly non-legal mechanisms. Consequences of such development is that the economy fails to reach its full potential, as will be discussed below. 17 Interestingly, these two starting points correspond roughly with the beginning of the two law-anddevelopment waves, Weber‟s in 1960s and 70s and North‟s in 1990s. 13

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a more complex, arms-length (market) system(see 3.2). Law does not have the same role throughout economic development, and so I propose that, unlike in the initial phase, absence of functional law at later stages actually hinders further growth. I will provide examples which show that China is already experiencing problems due to imperfect or even missing laws, and argue that remedying such inefficiencies and enabling further growth are only possible with more appropriately designed, stronger, and better-enforced law. 3.1. Role of law in China’s development so far. At first glance, China‟s miraculous growth occurred entirely without law‟s assistance and was instead supported by various extra-legal substitutes (e.g. social norms, reputation mechanism, networks for information-sharing and enforcement). But at closer inspection it becomes clear that law has existed and supported China‟s growth from quite early on. 18 Due to space constraint I focus on corporate/commercial law, but its functioning relies on other laws, including administrative, constitutional and criminal laws that provide the overall environment and so co-create conditions for development. Laws defining people‟s obligations and setting out punishments for wrongdoing existed in China‟s imperial past, but were secondary to extra-legal Confucian moral code and social norms (which relied on the concepts of reputation, „face‟, and personal networks known as guanxi). 19 Confucianism-inspired social norms still influence people‟s values in modern China,20 but are slowly being phased out in the commercially-savvy parts of China.21During the power struggle that followed the fall of the Qing Empire in 1911 there were several attempts to introduce a legal code in China but neither was very successful or long-lived. When Mao came to power in the aftermath of the 1949 Revolution, all laws were abolished NB it is true that law plays different role in China than it does in the US or the UK in that its enforcement is not equally effective and various non-legal influences are present in its implementation and enforcement. However, law is present and has a role to play. It serves as a signal of the government‟s agenda, and is increasingly relied on in various hybrid mechanisms, particularly where foreigners are involved (e.g. prepacks dealing with companies‟ insolvency – the solution is agreed before, but is formatted in accordance with the law and is sanctioned by the courts). Source: author‟s interviews in China and Hong Kong 19 See e.g. L. LADANY, Law and legality in China, University of Hawaii Press, 1992, at 59 On the rule of law in China see R. PEERENBOOM, China’s Long March Toward Rule of Law, CUP, 2002 20 R. TOMASIC, P. LITTLE, A. FRANCIS, K. KAMARUL and KH WANG, Insolvency Law Administration and Culture in Six Asian Legal Systems, Australian Journal of Corporate Law, 1996, at 248 – the interviews therein confirm the importance of Confucianism and offer possible explanations of its lasting impact 21 Confirmed by my interviews in Xiamen, Hong Kong and Shanghai in 2012-14 18

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and replaced by very basic, non-specialist written rules that could be easily changed if necessary. Mao abhorred the law because he believed it suffocated the free flow of revolution and served as a capitalist tool of oppression, and so the rule of law didn‟t apply and the Party enjoyed absolute power. There was a legal vacuum, with an occasional trial-and-error regulation which could be repealed any time. This continued until 1954 when the first Constitution was enacted and administrative laws were passed.22 The effect of ever-changing rules together with the Party‟s propaganda against the rule of law23 was that it became natural to distrust the law. The situation further worsened in the last fifteen years of Mao‟s rule. The lack of administrative and legal structure to manage such big state led to the failure to deal with a series of natural disasters and political tensions which in turn led to the death of at least 45 million people in the Great Famine in 1958-62,24 and eventually also to the disastrous civilwar-like Cultural Revolution in 1966-76. Over the decade, the Red Guards (self-appointed police) humiliated and killed millions of intellectuals and people who opposed the regime, with no trials and no laws to protect them. As Ladany, a long-term resident and observer of China put it: „This was lawlessness organised from above. […] Law, in any intelligible sense, was at an end.‟25 The ensuing anarchy pushed China‟s already fragile economy back into the dark ages. Mao‟s anti-law regime and bad leadership led to economic stagnation which was only defeated and the economy only truly started developing as a result of Deng Xiaoping‟s promarket reforms, from 1978 onwards. 26 Learning from China‟s fast-developing neighbours (including Hong Kong, Taiwan, South Korea and Singapore) Deng recognised the weaknesses of planned economy and realised that China can never reach its full economic potential without economic reforms. The problems were deep-rooted and ubiquitous: stateIn the years 1958-66 not a single law was enacted in China; the Party‟s position was that „Laws are odious: they tie hands of the leaders‟ (LADANY (n.20) at 55) 23 E.g. in 1959 the Research in Politics and Law (monthly paper) argued that the „Law cannot be defined precisely, for objective reality is too complicated it develops and changes indefinitely. Laws would tie the hands and feet of the Party workers and the masses, and would handicap both the fight against the enemy and the development of production… The law of our country is a changing law adapted to the perpetual revolution… Since the policy of the Party is the soul of the legal system, legal work is merely the implementation and execution of the Party‟s policy‟ (quoted by LADANY (n.20) at 69) 24 See e.g. F DIKOTTER, Mao’s Great Famine, Bloomsbury Publishing, 2010 25 LADANY (n.20) at 73 26 China‟s GDP per capita was only US$155 in 1978, US$1,041 in 2001 when it joined the World Trade Organisation, and US$6,807 in 2013. For comparison, United States‟ GDP per capita was US$10,587 in 1978, US$37,286 in 2001 and US$53,143 in 2013: World Bank 22

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owned enterprises (SOEs) were inefficient, the workforce lacked incentives to work harder, the financial sector was badly underdeveloped, and there was a lack of expertise and foreign trade and investment. Deng focused less on ideology and more on effectiveness of his policies. His radical internal reforms lay foundations for China‟s gradual transformation into a „socialist market economy‟27 and opened it up to the world market.28 This led to liberalization of the economy, companies‟ higher profits, more market-based prices, emergence of a simple capital market and unprecedented growth. Unlike Mao, Deng saw law as an indispensable tool for ensuring sustained development of socialist China. He believed that in order to formalise and consolidate the achievement of economic reforms, to bring stability, prevent abuse and enable further growth, it was crucial to build a stable and predictable environment which could be provided by a strong legal system.29Ministry of Justice was re-established in 1979 (closed in 1959), and 1980s saw a shift towards perceiving legal system as necessary for much-desired social and economic development.30 The 1982 Constitution, although minimalistic, lay foundations for a greater role of the rule of law in China. It was amended several times, inter alia in 1988 to legitimise the existence of the fast-developing private sector, and in 1993 to formalise the „socialist market economy‟ direction.31New criminal and administrative laws were passed in 1979, and soon after, throughout 1980s, all basic corporate/commercial laws were introduced. New law graduates began to flow into the system from the re-opened law schools all around China. The nation-wide changes were important, and introduction of a clear set of formal laws and regulations provided more structure to arranging people‟s affairs. But crucial to enabling China‟s growth was the establishment of special economic zones („SEZ‟) where local promarket reforms (e.g. tax incentives, introduction of extensive land use rights, promotion of private and foreign investment, governance of imports and exports, etc.) resulted in creation For discussion of ideological and economic transformation see A. WEDEMAN, From Mao to market: rent seeking, local protectionism, and marketization in China, CUP, 2003; A. CHAN, R. MADSEN and J. UNGER, Chen Village under Mao and Deng, UCP, 1992, Chs.11-12; M. MEISNER, The Deng Xiaoping Era: An inquiry into the fate of Chinese socialism, Hill and Wang, 1996 28 For a more detailed discussion see e.g. HASAN in V. POLLARD (ed), State Capitalism, Contentious Politics and Large-Scale Social Change, Koninklijke Brill, 2011, at 157-8 29 Y ZHANG „On the Strengthening the Socialist Legal System‟ 6 Social Sciences in China (1981); J CHEN, China: Constitutional Changes and Legal Developments, in A TAY and C LEUNG, Greater China – Law, Society and Trade, Law Book Company, 1995, at 139-183 30 See e.g. Zhang (n.30); L LADANY, The Communist Party of China and Marxism, 1921-85, Hoover Institution Press, 1988 31 For commentary see e.g. S. CHEN, Our Legislative Trend in the 1990s, Guangming Daily, 9 March 1994, p.5; S. CHEN, The Legislative Train is Speeding Up towards market Economy, Legal Daily, 2 January 1994, p.3 27

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of China‟s first fast-growing economic centres. SEZs started developing in 1980s and served as policy labs. Their setting up, existence and success relied on well-tailored, efficient laws that provided a stable and predictable environment for domestic as well as international investors. 32 Moreover, the incoming investors brought in capital, capable management and technical knowledge, all of which further bolstered China‟s economic development.33In the end, the laws that proved successful in SEZs were later implemented nation-wide, further accelerating the successful reform movement with comparatively minimal costs or mistakes.34 In short, Deng‟s initial economic reforms were indeed supported and strengthened by a multitude of laws. But law played even bigger role in China‟s subsequent growth.35 I will illustrate this by discussing the role that law has played in the introduction of private ownership, and in the opening-up to international trade, both of which were crucial for further economic growth.36 One of the sources of China‟s subsequent growth was the legalisation of private ownership. 37 Although introduced in the initial phase, 38 private ownership only fully flourished after Deng‟s 1992 Southern Tour when he encouraged further development and innovation by, inter alia, famously declaring that “some should be allowed to get rich

C PAK, The Special Economic Zones of China and Their Impact on Its Economic Development, Praeger, 1997 See e.g. L. WHITE, Unstately Power: Volume 1, M.E. Sharpe, 1998 34For example the bankruptcy law was first developed in Shenzhen, and only when it proved successful it was implemented nation-wide: X ZHANG and C BOOTH, Chinese Bankruptcy Law in an Emerging Market Economy: The Shenzhen Experience, Columbia Journal of Asian Law, 2001, p.1 35 In other words, I propose that initially law played a more ex post supportive role, while in subsequent development it was a contemporaneous force and later even ex ante cause for development. 36 N LARDY, The Role of Foreign Trade and Investment in China's Economic Transformation, The China Quarterly, 1995, p.1065; A SZAMOSSZEGI and C KYLE, An Analysis of State-Owned Enterprises and State Capitalism in China, US-China Economic and Security Review Commission, 2011 37 Private ownership first took the form of an illegal local initiative by the local governments in China‟s countryside. Proving successful, Deng supported it realising that any profound change must start in the countryside where at the time lived about 80 per cent of the population. A responsibility system was introduced in 1979 whereby communes were dismantled and farmers were encouraged to form small groups. They could choose which crops to grow and were allowed sell any surplus for profit. And it paid off as the agricultural productivity grew by about 30 per cent (from 305 million tonnes in 1978 to 407 million tonnes in 1984): J. KYNGE, China Shakes the World – The Rise of a Hungry Nation, Weinfeld& Nicolson, 2006, at 14; see also TAY and LEUNG (n.30), Ch.2 38 When crowds of able, educated people were released from the re-education camps (akin to Soviet gulags) in the countryside and flooded cities which had no jobs for them, the government realised that the best and quickest solution is to allow them to start their own little businesses, and so in early 1980s first private micro-businesses were opened in Beijing and other big cities. Private enterprises were formally allowed in 1988 and certain coastal areas (Pearl River Delta near Guangzhou; Zhejiang and Jiangsu Provinces ear Shanghai) started growing into commercial centres. 32 33

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first.” 39 His words were supported by a series of corporate laws and legal initiatives. The enormous expansion of private sector in terms of size and importance 40 was eventually recognised in 2003 when the Constitution was amended to grant the same protection to private property as enjoyed by state property (and private entrepreneurs same rights as those of SOEs). Previously SOE-focused commercial laws were reformed to provide rules for privately-owned businesses. The private sector has been growing since41and is now major source of China‟s continued economic growth.

42

Private enterprises provide more

employment than SOEs (more than half in 2010), produce more exports (twice more than SOEs in 2010), introduce more technology and innovation, account for most new jobs (80 percent of new urban jobs in 2010), re-employed some 19 million workers laid-off by SOEs, and generate needed tax revenue (800 billion RMB, or 11 percent of total tax volume in 2010).43 Apart from generating growth per se, the emergence of a strong private sector has exposed the inefficiencies of centrally-managed SOEs which were consequently partly opened up to public scrutiny and forced to compete for customers and resources with new entrants on the market,44and with some smaller, mostly unprofitable SOEs slowly privatised. Second illustration of law‟s contribution to China‟s subsequent economic development is its role in enabling international trade and foreign investment in China‟s previously closed market. SEZs were the first to open doors for foreign investors and traders into Chinese 39Selected

Works of Deng Xiaoping, Vol III, People‟s Publishing House, 1993 This growth was reflected in the exponential growth of its GDP per capita and other financial indicators. China‟s GDP per capita was US$363 in 1992, US$1,135 in 2002 and US$6,093 in 2012: The World Bank. See also K TSAI, Back-Alley Banking: Private Entrepreneurs in China, Cornell UP, 2002; W. LI, Small and medium enterprises – the source of China’s economic miracle, China Express, 2012 available at http://sydney.edu.au/china_studies_centre/china_express/issue_3/features/small-and-mediumenterprises.shtml 41 At first state retained at least partial ownership and control of new companies, but in time completely private and in time also foreign enterprises were allowed to operate. In 1997 it was decided that the state would relinquish control of small and medium enterprises (“SMEs”) and their newly issued shares were offered to their managers and staff. The privatization was substantial but relatively quiet, and state ownership fell by 40% in the first five years alone: K GUO and Y YAO, Causes of privatization in China, Economics of Transition, 2005, p.211. See also B NAUGHTON, Growing out of the plan, CUP, 1996; KYNGE (n.38) 42 LI (n.41) estimates that private sector contributes more than 60% of China‟s GDP; V. NEE and S. OPPER (Capitalism from Below: Markets and Institutional Change in China, HUP, 2011) estimate it is 70% of China‟s GDP. See also Y HUANG, Private Ownership: The Real Source of China’s Economic Miracle, McKinsey Report, December 2008 43 See LI (n.41), and ALLEN, QIAN and QIAN (n.10) 44 See e.g. D CLARKE, Corporate governance in China: An overview, China Economic Review, 2003, pp.494: 497 40

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market,45 initially through joint ventures and in time also foreign direct investment (FDI). The law regulated foreigners‟ entrance, exit and permitted activities, and in return provided relatively safe and predictable environment in which to operate. It is questionable whether without law such invasion of foreign investors could ever take place, since, aside from China‟s original political opposition to foreign presence, outsiders lack access to the information and exchange networks on which insiders tend to rely. 46 In other words, most risk-averse investors prefer if, firstly, they are not disadvantaged compared with domestic actors; secondly, they are reasonably protected against unexpected occurrences due to local variations which are hard or impossible to foresee; and thirdly, the system of rules is similar to the one they are used to operating in,47 all of which law can provide. Opening up to foreign trade was beneficial for both sides: for Chinese government it provided a chance to get foreign money and know-how into Chinese nascent market economy with the benefit of definite limitation on the presence of foreign capitalist influence; and for foreigners it offered the much-desired (albeit not always maximised) opportunity to get access to the one-billion-person market. Moreover, as a result of the opening up, foreign trade increased from 7 to 37 percent of GDP between 1978 and 1998,contributing to the double-digit growth of China‟s economy.48 Although Chinese government has not refrained from interfering with the economy as the conventional law and development literature proposes, it is arguably the right approach to ensure smoother transition from relational dealings to the market.49 The government has been gradually releasing its grip on certain aspects of commercial life, including ownership, control, taxes, investment, etc., and it has chosen to do so largely through formal law. The legalisation process has been slow and at times without single direction, 50 but it has been supporting the transition of the commercial environment in which not only relational dealings The process of opening up started after US President Nixon‟s visit to China in 1971, but there was no legal framework to enable foreign investment until late 1970s/early 1980s. It was not until the Shenzhen SEZ was opened in 1979 that open door policy truly started: see Tay and LEUNG (n.30) Ch.4 46 J LANDA, A theory of the ethnically homogeneous middleman group, Journal of Legal Studies, 1981, pp.346-362; R. KALI, Endogenous business groups, Journal of Law, Economics and Organization, 1999, pp.615-636 47 See e.g. C MILHAUPT and K. PISTOR, Law and Capitalism: What Corporate Crises Reveal about Legal Systems and Economic Development around the World, University of Chicago Press, 2008, p.192 48 G CHOW, Economic Reform and Growth in China, Annals of Economics and Finance, 2004, at 127:131 49Particularly considering the damaging „shock therapy‟ approach combined with fast shrinkage of state‟s powers applied in the transition of Central and Eastern European states in early 1990s: M MYANT and J DRAHOKOUPIL,Transition Economies, Wiley, 2011, Ch.5 50The change in political leadership tends to have an impact on China‟s socio-economic plans. 45

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between known parties, but also arms-length dealings across time and distance can take place with relative predictability and certainty, and so increase the overall turnover volume and in time also efficiency of exchange. This is what we turn to next.

3.2. Extra-legal substitutes, law and economic development. All dealings rely on individuals‟ ability to make credible commitments to one another. In simple relational dealings mechanisms like trust and reputation (supported by social norms) suffice, while purely arms-length, complex dealings are instead supported by multilayered legal structures (formal law).51As the nature of the players changes and before a functioning, reliable formal law nexus is created, the players must develop and rely on a myriad of extralegal (i.e. non-law) substitutes. These range from reliance on the existing social norms (especially where strangers can bind each other through a credible mechanism, such as reputation, membership or licensing) to mechanisms relying on the existence of formal law as the ultimate outside option and threat if private negotiations fail (e.g. contracts, fiduciary duties, etc.52). State control and interference is also used during transition instead of the nonexistent or imperfect formal law. 53 However, all the substitutes have limitations which become particularly pronounced once the economy has fully utilised the potential of relational dealings, and needs to explore the potential profits arising from arms-length dealings in order to sustain and support further growth. Once that happens, extra-legal rules do not become obsolete, but simply become one of many tools to choose from.54Let us now look at these rules in more detail, focusing particularly on the role that law plays in later stages of the transition.

51This

is consistent with the above discussion of China‟s growth where the initial development was merely supported by law ex post, but as the economy developed further, law took on more active role, sustaining economic growth simultaneously or even causing change ex ante. 52 The existence of public ordering mechanism strengthens the credibility/reliability of private ordering: N. FROME, Multi-creditor restructurings in transition countries, EBRD, 2013, p.50:52-3 53 See R COOTER and H SCHAFER, Solomon’s Knot, Princeton UP, 2011, at 18: “Under communism, state planning displaced markets, nationalized industries dwarfed private ownership, and public law crowded out private law. Even so, stable bureaucracies gave officials economic power somewhat like property rights, and political bargains created obligations resembling contracts” 54Formal and informal rules coexist: COOTER and SCHAFER (n.54) at 35; MILHAUPT and PISTOR (n.48) at 193. Moreover, formal rules often rely for their content and/or legitimacy on informal rules: R. ELLICKSON, Order Without Law, HUP, 1991; R POSNER, Social Norms and the Law, American Economic Review, 1997, p.365; P. HUANG and H. WU, More Order without More Law, Journal of Law, Economics, and Organization, 1994, p.390

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In terms of economic theory, whether or not two parties interact depends on the (costeffective) availability of information, monitoring and enforcement. The information is necessary to evaluate the risk involved in the transaction itself and in transacting with the particular counter-party. The monitoring is necessary to ensure that both parties honour their sides of the agreement. And the enforcement is necessary to prevent any wrongdoing ex ante and/or to punish the wrongdoer ex post. At the beginning, in relational dealings, counter-parties tend to know each other and often also share same social norms55 so they have access (directly or indirectly) to the necessary information. Their transactions take place in closely-knit, familiar and geographically close groups, over short periods of time, and so monitoring is also relatively cheap and easy. Enforcement is similarly straight-forward: given that the social norms are often internalized, counterparties often enforce cooperation (i.e. repay money, respect agreement) against themselves, without need of second- or third-party enforcers.56 Alternatively, people rely on physical violence (in one-period interaction) 57 and reputation mechanism (in repeated interaction) to enforce compliance.58 Reputation mechanism59 is particularly important once counterparties know they might wish to do business in the future. It enables trade by increasing the payoffs of cooperation which would otherwise be impossible. Economic theory predicts that both counterparties benefit

55i.e.

informal rules that govern the behavior and order of society. They evolve spontaneously over time from bottom up (i.e. through instinctive repeated behavior of a group of people which in time becomes the norm) in closely knit groups (GREIF (n.66)). They are based on social equilibria, mostly unwritten but shared by a large group/part of society (S DEAKIN, Legal Evolution, LSR Paper Series, University of Cambridge, September 2011, p.12 56 There are studies showing that the Chinese put pressure on themselves because of an internal moral code (S. HSU, Informal Finance in China: American and Chinese Perspectives, OUP, 2009,p.26), and a strong bias toward cooperation in China where many people view themselves in terms of how they relate to others in the society, like family and friends (M LI and C HSU, In-group favouritism and development of communal identity, Indigenous Psychological Research in Chinese Societies, 1995,p.150) 57 More data on this mechanism is needed, but various interviews confirm the existence of such enforcement mechanism (see e.g. TOMASIC et al (n.21)), as do occasional articles in the Chinese newspapers describing cases of violent revenge and enforcement. 58 Such extra-legal mechanisms tend to be very efficient, particularly in transition systems – see ALLEN, QIAN and QIAN (n.10) at 60 59 Reputation is linked with the Chinese concept of „face‟, and to „lose face‟ means to lose status and trustworthiness within one‟s social group and with it all the benefits of being a member of such group entails: see Q DONG and Y LEE, The Chinese Concept of Face: A Perspective for Business Comunicators, at http://www.swdsi.org/swdsi07/2007_proceedings/papers/401.pdf; HUANG and WU (n.55)

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most if they cooperate.60 If A lends $100 with an interest rate of 50 percent to B who invests the funds and earns a return of 100 percent, B can then (a) repay A $150 and keep the excess $50 (i.e. cooperate), or (b) not repay A and keep $200 (default) with A suffering a loss of $100. Thus, although the welfare-maximizing strategy is for A to lend and for B to repay (end result is $150 repaid to A + $50 kept by B), B has an incentive not to repay because then he can keep the higher payoff of $200 (not $50 as per the agreement). 61 A, as a rational lender, would therefore not lend and the lending market would collapse.62 The payoffs change with the introduction of multiple periods into the game, because A‟s failure to repay would cost him the opportunity to borrow from A in the future. In economic terms, B‟s payoffs are altered to reflect the value of keeping/losing his reputation as a function of his future access to funds and position in the society. Reputation (i.e. information about whether B is likely to repay) thus introduces a strong incentive for B to repay in the present period because if he fails to repay, B keeps only $200 from the present round, but if he repays he gains potentially much larger product of the one-period gain of $50 multiplied by the number of remaining rounds of future trade.63 Where a player doesn‟t have an established reputation, it may be impossible for him to enter the market due to his inability to signal his (good) quality. This is a situation where interacting parties do not know each other personally. The resulting information asymmetry can be overcome by borrowing someone else‟s reputation through a mechanism known as reputation pooling. An individual can vouch for a newcomer who can in time establish his own reputation. 64 Alternatively, a group of individuals can come together to boost the Known as prisoner‟s dilemma – it is personally beneficial not to cooperate, but the overall payoff is greater if the counterparties cooperate. 61 This model is based on the assumption that the players are self-interested, however, this assumption might be weakened in China by the concepts of reciprocity (bao) and social relationships (guanxi): O. BEDFORD and K. HWANG, Guilt and Shame in Chinese Culture, Journal for the Theory of Social Behaviour, 2003,p.127. The phenomenon of internalization of cooperative norms is explored in R. COOTER, Do Good Laws Make Good Citizens?, UC Berkeley Law & Economics Research Paper No. 20008, 2000. He argues that that over time reputation mechanism leads parties to internalize norms because this makes them more trustworthy trading partners and so they secure more business. 62 In economic terms, A‟s decision not to lend is the Nash equilibrium, i.e. a strategy that is best for both players when taking into account the other player‟s strategy, where neither payer is better off by any other strategy. 63 NB: For the purpose of this model, I am keeping the interest rate constant at 50 percent, but in real life „good‟ behaviour often leads to lowered interest rates for the borrower, and so retention of greater part of the profit. 64 It is up to the reputation intermediary to enforce repayment, otherwise he risks losing his own reputation (not only his defaulting client‟s). This has been used at the inception of inter-provincial trade in 60

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reputation of individual members and underwrite each other‟s obligations vis-à-vis the outside traders.65 A further alternative is signalling one‟s intention to become and remain a member of a closely-linked group and adhere to its rules by providing a costly hostage that would be lost if one defects.66 Thus, the reputation of all members would be damaged if any one of them defected, which incentivises intense internal monitoring and enforcement. Reputation mechanism is an important substitute, but it can only function well when the parties are inter-related in some way. As the economy grows, the individuals want to capture greater audience and offer more than others, and so are sooner or later forced to interact also at arms-length, 67 i.e. with unfamiliar counterparties, and to do transactions that are more complex, longer-term, and over greater distance. In such dealings the counterparties‟ immediate access to information as well as their ability to monitor and enforce in a costefficient manner is greatly diminished, and so new mechanism is called for to regulate these relationships.68In other words, once the economy reaches the point where there is not enough new trade arising from purely relational dealings69 and when more arms-length dealings are called for to ensure further development, different rules becomes necessary to regulate the trade. Arms-length dealings are usually regulated through formal law or its key substitute, state control. Law provides objective, fixed rules that determine outcomes of individuals‟ actions and form individuals‟ incentives to act in a certain way (or else be punished) 70 which helps

China, where local government official acts as a reputation intermediary in non-relationship-based transactions because he wants to get as much trade as possible into his provincein order to get more benefits from central government (praise and money) and bribes and/or fees from the borrowers. He, therefore, has an incentive to protect his reputation to ensure such gains continue in the future, and so enforce the borrower‟s promise to repay. See e.g. S HUANG, A Study of Contract Enforcement Mechanisms in China during Transition, Journal of Legal and Economic Studies, 2006,p.192 65 This form of reputation pooling is often exercised by the state. See also A GREIF, Reputation and Coalition in Medieval Trade: Evidence on the Maghribi Traders, Journal of Economic History, 1989, p.857 66 This mechanism is known as guanxi in China and blat in Russia. See A LEDENEVA, „Blat and Guanxi: Informal Practices in Russia and China‟ (2008) Comparative Studies in Society and History 118; K. XIN and J. PEARCE, Guanxi: Good connections as substitutes for institutional support, Academy of Management Journal, 1996,p.1641 67In addition to the established relational trade 68 Social norms are unknown to outsiders and their understanding needs time. Similarly, reputation needs to be built over time, and even reputation pooling is limited by the intermediary knowing the parties. 69 The range of potential relational partners is limited, and so sole reliance on relational dealings may prevent potentially beneficial trade with persons outside of such group 70 MILHAUPT and PISTOR (n.48) at 10

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coordinate and manage relationships in the market.71Transparency and predictability that law provides lead to reduction of information asymmetries, which in turn lowers the risk of transacting, and so leads to more investment.72Effective contract law helps lower the cost of information production and monitoring, and ensures enforcement of promises through credible commitment mechanism it creates 73 which encourages more transactions, with a wider range of partners, allowing for more complexity and larger scale. 74 Contract law also helps overcome the incentive to default in one-period transacting (if supported only by reputation mechanism), because it imposes punishment for default. This in turn enables companies to grow, take advantage of dispersed production, best price on the market without fear of unpunished fraud, and create and participate in wider market. In other words, through fostering appropriate expectations 75 on which the parties can base their risk and profit assessment, the investors are more likely to invest more and with more favourable conditions.76 Law that protects and defines property rights is also crucial for enabling the market participants to provide and receive finance. Capital is critical for proper functioning and growth of economy, particularly for the private sector,77 and property rights allow it to be effectively deployed. 78 Studies show that well-functioning and flexible financial markets develop where the investors‟ money and innovators‟ ideas are protected, 79 where complex

Often, multiple equilibria exist, and the laws navigate the parties to the one(s) preferred by the lawmaker. This includes prevention of undesirable activities such as white collar crime, hostile takeovers (MILHAUPT and PISTOR (n.48) at 31), and ensures production of public goods and limitation of harmful externalities (COOTER and SCHAFER (n.54) at 209) 72K. JAYASURIYA (ed), Law, Capitalism, and Power in Asia: The Rule of Law and Legal Institutions, Routledge, 1999 73 COOTER and SCHAFER (n.54) at 7; D. CLARKE, P. MURRELL and S. WHITING, The role of law in China's economic development, GWU Law Research Paper No.187, 2007 74 COOTER and SCHAFER (n.54) at 7 75 ACEMOGLU, JOHNSON and ROBINSON (n.6);DRODRIK, A SUBRAMANIAM, and F TREBBI,Institutions rule: the primacy of institutions over geography and integration in economic development, Journal of Economic Growth, 2004, p.131 76 CLARKE, MURRELL and WHITING (n.74) p.375; MILHAUPT and PISTOR (n.48) at 31; NORTH 1990 (n.5) 77 I. HASAN, P WACHTEL and M ZHOU, Institutional development, financial deepening and economic growth: Evidence from China, Journal of Banking and Finance, 2007,pp.157-170:159 78 H. De SOTO,The Mystery of Capital, BasciBooks, 2000 79 COOTER and SCHAFER (n.54) at 64 argue that growth will follow where “the makers of wealth [can] keep much of it [which will make them] incentivised to make it in the first place” 71

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financing arrangements are safeguarded against abuse 80 and where accurate information is available to overcome the lack of personal knowledge of the counterparties‟ history. 81 Once the basic property rights are established (enabling simple loans and personal property entitlements) it is useful to increase the availability and utility of collateral.82 The first step is enabling the parties to clearly identify the assets which serve as collateral. Second step is to create a reliable mechanism that enables the parties to charge thus identified assets. Third step is to enable anyone to find out about any existing liabilities associated with a given asset. To maximise the utility of the charged assets, it is then necessary to create an environment in which real property used as security can be safely left in borrower‟s possession and used by him, so that the security can continue to be commercially used. In advanced market economies, a further step is taken to enable securitisation of contingent and future obligations. Law is irreplaceable in these transactions. However, in China and other transiting countries arms-length dealings are often regulated by the state instead of the law, and some argue that state control is, indeed, more efficient.83 It is true that unpopular changes are easier to do in autocratic regimes and that state ownership substitutes property rights, extensive state involvement replaces corporate governance and contract law, and reduces information asymmetry, state central planning can be used instead of market mechanism for allocation of resources, and internal mergers and bailouts act as substitutes for bankruptcy law. State, therefore, can perform many functions normally performed by law. But although state control plays an important role, its significance is most pronounced at the beginning of development.84State power can ensure that agreements take place and are enforced, but it does not necessarily ensure that the counter-parties are coupled with the best partners, that limited resources are allocated to the most efficient user, or that sufficient financing is available to worthy projects. Particularly where the state protects its own interests (e.g. state-owned subjects, full employment, social stability, etc.) its enforcement becomes uneven and skewed which can lead to disastrous results. For example in MILHAUPT and PISTOR (n.48); D. ARNER, C. BOOTH, P. LEJOT and B. HSU, Property Rights, Collateral, Creditors Rights, and Insolvency in East Asia, Texas International Law Journal, 2007, p.515: 524 81 This is connected with the fourth function, above, where law encourages information collection and sharing 82ARNER et al (n.81) at 529 83 R GILSON and C MILHAUPT, Economically Benevolent Dictators: Lessons for Developing Democracies, American Journal of Comparative Law, 2011, pp.227-288 84 This was the case in China as well as India, Japan, Korea, Taiwan and Malaysia in 1960-1995: see a summary of empirical studies across these countries in GINSBURG (n.9) 80

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China this has led to the creation of too-big-to-fail SOEs which provide employment, social welfare, housing, etc., but which are extremely inefficient and often loss-making.85 Another example is China‟s banking sector which lends based on political order rather than financial analysis and needs to be bailed out regularly. 86 A further example is Russia where statefavoured and state-related oligarchs control business and so limit socio-economic growth of the majority of society, not to mention the shocking wealth disparity.87 Moreover, research confirms that economic development results in greater demand for law, particularly when the policy shifts to reliance on market mechanisms.88State control usually leads to diminished transparency, and outsiders are often excluded or treated in an unpredictable and/or unfair manner. Moreover, the adjudicators under state control tend to be biased in favor of the controlling body (preferring certain groups/individuals and certain values instead of applying the rules objectively and independently) which can create an anticommercial environment where outsiders cannot know or trust the system, and so are reluctant to invest which can lead to money shortage and slow-down in development. 89 This supports my argument that law plays greater role at later stage of development: while law has at best supportive role in relatively simple, relational dealings which are sufficiently regulated by extra-legal substitutes, as the economy transitions to greater reliance on armslength dealings these substitutes are no longer sufficient on their own and so law is needed to co-create and sustain economic development. Although China has been showcased as a counterexample to the traditional law and development thesis that law matters in economic development, the lack of effective law has already caused some serious problems in China. Access to cheap capital is crucial for companies‟ growth, but financing arms-length transactions is difficult without supporting laws.90Although equity financing and financial intermediation have been relatively successful

See SZAMOSSZEGI and KYLE (n.37) See ALLEN, QIAN and QIAN (n.10); KYNGE (n.38). In China, the official estimates say there were non-performing loans worth about $164 billion (private observers‟ estimates claim $800 billion) in Chinese economy due to policy lending: K. LINTON, Access to Capital in China, Journal of International Commerce and Economics, 2006, p.27:31. The situation is similar in Russia: L LAEVEN, Insider Lending and Bank Ownership: The Case of Russia, Journal of Comparative Economics, 2001,p.207 87D HOFFMAN, The oligarchs: Wealth and power in the new Russia,PublicAffairs, 2003 88 See GINSBURG (n.9) 89 Q ZHANG, The People's Court in Transition: The prospects of the Chinese judicial reform, Journal of Contemporary China, 2003,p.69 90Largely due to information asymmetries. See e.g. XU (n.8):1080 85 86

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in China thanks to numerous laws and regulations,91 only limited number of companies (i.e. listed companies) can benefit. Research shows that small, private companies in particular rely on debt financing,92 but in China most private companies do not have access to bank finance, and so have to rely on shadow credit93 which is much more costly (which limits their growth) and unregulated (which has potentially damaging impact on China‟s overall financial stability). The bankruptcy law, although (objectively-speaking) well-written, is hardly ever used which leads to value destruction in case of restructurable companies and restricts the availability and quality of capital.94The imperfect or missing property law means that it is unclear who actually owns particular property or whether it is burdened by any security interests. Moreover, the inability to protect one‟s intellectual property rights have limited original research and development and have allowed piracy as well as production of plagiarised scholarly work, neither of which create any new value. The problems with ensuring fulfilment of contractual promises have led to unstable commercial environment without trust and so limited arms-length interaction, and even infrastructure failures such as bridge collapses and road unsafely.95The lack of consumer protection laws has also led to scandals concerning lethally tainted drugs and food products (e.g. the Sanlu milk case) and unsafe toys and manufactured goods. And inefficient environmental laws have failed to prevent environmental disasters such as poisonous pollution in large cities and petrochemical spills.96 I propose that in the absence of functional law, i.e. a reliable and objective structure that can ensure smooth functioning of China‟s increasingly complex institutions, further development in China is seriously endangered. Although China has been growing (albeit slowing down in recent years), its GDP per capita is still deep below any developed nation, and so it is still far away from having reached its full economic potential. I therefore propose that based on the Stock exchanges were opened in Shanghai and Shenzhen in 1990-91 and have been regulated since 1992. See YAO and YUEH (n.8): 756 92 See e.g. A BERGER and G UDELL, The economics of small business finance, Journal of Banking & Finance, 1998,p.613 93 Financial markets in most developing economies are segmented into formal and informal parts as a result of credit constraints, serving different types of borrowers and operate under different conditions: E. YALDIZ, Y. ALTUNBAS, and F. BAZZANA, Determinants of Informal Credit Use: A Cross-Country Study, Midwest Finance Association 2012 Annual Meetings Paper 94 WORLD BANK, Debt Resolution and Business Exit, Viewpoint, July 2014 95 Knowing that breaking contractual promises leads to no punishment, it is rational (in economic sense) to default and not fulfil contractually agreed but expensive safety requirements. 96 For discussion of these and further issues see D LAMPTON, Following the Leader, UCP, 2014, Ch.1 91

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discussion above, enabling further growth is only possible with more appropriately designed, stronger, and better-enforced law.97

4. Conclusion. Although it is true that prima facie China‟s growth does not seem to support the general thesis that only strong law can support strong economic performance, I believe that China‟s economic development was initially co-supported and subsequently formalized and boosted by law. I have suggested that law matters, but it is clear from the previous discussion that it matters to greater or lesser extent depending on the stage of transition of the economy, and formal law is never sufficient alone since, through choice or necessity, state does not regulate all areas of human activity, and so social norms and other extra-legal substitutes are needed98 to fill the gaps. China‟s own development, I argue, confirms that law matters at later stages of economic development when complex, arms-length dealings support further growth. I therefore propose that the law and development theory needs to be refined to reflect the benefits of extra-legal substitutes at early stages of development, the changing roles of law throughout transition, and the importance of appropriate design of formal laws at later stages of economic development.

97Discussion

of appropriate design of laws if beyond the scope of this paper. Nevertheless, the important issues to keep in minding are likely to include the stage of development (mix of relational and arms-length dealings) so as to determine the best mechanism for information sharing, monitoring and enforcement; content of the proposed law; the environment in which the law is to operate (corruption, judiciary, political interests, domestic and international constraints, etc.) including linkages with policies, social norms and laws already in existence; resources for the implementation; time-frame of implementation; etc. 98As well as often being cheaper and easier to use

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