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 1994-2001 (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

0.2 0.12 25

China 0.4 0.16 68

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 (1994-2002) 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 1993-2001, 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

S O E A 1 S O E A 2

P ro v in ce A

S O E B 1 S O E B 2

P ro v in ce B

C e n tra l G o v 't

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/regionalQuota (# 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)

•  

Sto

ck Q

uota

Grow th in Market Cap

.750212 35.6099

.413074

13.782

ShanghaiAnhui

GuangdonHainan

Fujian

Heilongj

YunnanShaanxi

Sichuan

Beijing

Shandong

Jiangxi

Zhejiang

Henan

Shanxi

Guangxi

Ningxia

Innermon

Xinjiang

Hubei

Tianjin

jiangsu

Chongqin

Liaoning

Jilin

Guizhou

Hebei

Gansu

Hunan

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

Sto

ck

Quota

Grow th in Net Profits

-.769484 1.9523

.413074

13.782

Anhui

Hainan

Jiangxi

Xinjiang

Henan

Shanxi

Guangdon

Guangxi

Hebei

Innermon

Sichuan

Heilongj

Shanghai

Fujian

Hubei

Shandong

jiangsu

Shaanxi

Beijing

Yunnan

Ningxia

Hunan

Gansu

Zhejiang

Liaoning

Guizhou

Jilin

Tianjin

Chongqin

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 1996-99

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