chapter  10
37 Pages

The relationship between law and economic growth in China

Introduction One of the enduring paradoxes in China’s remarkable economic growth experience over the three decades since 1978 is the lack of a well established legal system supporting the increasingly decentralized, marketizing economy (see, for example, Allen et al. 2005; Cull and Xu 2005). It is a notable puzzle in that robust institutions are thought to be required both in theory and in practice to support markets (see, for example, Acemoglu and Johnson 2005). For instance, in a Coasian or Walrasian sense, a market economy is predicated on well defined property rights and low transaction costs that permit efficient exchange to take place (Coase 1937). The rapid transition experience of many other economies such as the former Soviet Union was in part predicated on the establishment of private property rights and removal of the inefficient state in the burgeoning market economy. In China’s case, however, much of its reforms have been undertaken without an established rule of law and in the absence of a change in ownership from state (public) to private. It raises the questions as to how China was able to instil economic incentives in the absence of private property rights and how an imperfect legal system could protect against expropriation that would normally limit investment and other private economic activities, particularly foreign direct investment (FDI). The gradualist and evolutionary nature of both economic and legal reform provides a basis for understanding the relationship between law and growth in China. The Chinese legal tradition is distinct from that of common law (UK, US) and civil law (Continental Europe) countries; although that does not negate the incrementalist nature of legal reforms which can exist in all legal systems (see Jones 2003 for the modern day influences of China’s dynastic legal system). Perhaps most evident in common law countries, law develops from case law – judicial pronouncements which give meaning to, and shape, the interpretation of the statutory laws. Common law itself is premised on cases furthering common laws. Stare decisis and precedent naturally carry significant weight in judicial rulings and in shaping the development of the rule of law. Law, therefore, develops over time rather than appears as a wholly formed system of a “rule of law.” Even in countries with a civil law tradition, laws are

evolutionary as comprehensive codification is not feasible and the state, including its administrative organs, largely takes on the interpretative role. In the law and finance literature, this debate has started to take shape for China. Chen (2003) argues that China’s financial development follows a “crash then law” path proposed by Coffee (2001). From a legal perspective, Coffee (2001) argues that capital market developments precede – and not follow – legal protection for shareholders. This runs contrary to the view of economists, namely, La Porta et al. (1997, 1998) who posit that the rule of law causes financial markets to develop (see also Acemoglu et al. 2005 for a similar argument regarding institutions and economic growth). Coffee (2001) offers evidence from the historical development of the US and UK, where dispersed ownership by shareholders arose with the establishment of their bourses in the nineteenth century and legal protection for minority shareholders came afterward, largely in the early twentieth century. His argument is premised on the creation of interested parties: legal reforms are enacted due to the agitations of a motivated constituency that believes that it will be protected by the proposed reforms. Therefore, he argues that the constituency must arise before it can become an instrument for legal change. Chen (2003) applies this approach to China’s capital markets and shows that an interested constituency arose after the creation of the two stock exchanges in Shanghai and Shenzhen in the early 1990s which led to the Securities Law of 1999. La Porta et al. (1997, 1998), by contrast, draw a distinction between common law and civil law countries and show that common law countries provide better shareholder protection which fosters the development of financial markets. Their argument is that legal protection allows markets to develop through providing protection against expropriation and improved contracting security; therefore, law creates markets. Allen et al. (2005) compare China against the La Porta group of countries and conclude that informal institutional arrangements, such as trust-based contracting, supplanted the role of law in fostering capital markets. Aside from the question of the sequence of law and market development, there remains a further mystery as to how markets developed in China in the absence of private property rights, which are typically established in law. Unlike the US or UK and even other transition economies which adopted private ownership early in their transition, China’s lingering communal property system should have impeded market development. Without property right allocations, transactions should have been hampered and the market stifled. Therefore, this paper will propose that legal and economic reforms – extending beyond financial development – give rise to, and reinforce, each other in China. Also, institutional reform through administrative dictates, such as the Contract Responsibility System that injected market forces into state-owned enterprises (SOEs), was sufficient to instil incentives to create markets in the absence of strong legal protection. Therefore, once a market is created by law or institutional reform (e.g. administrative dictate or absence of notable prohibition), then interested constituencies and stakeholders will push for more formal and explicit legal reforms to protect their interests. Better legal protection in turn

promotes market development by providing greater security of economic transactions. Informal, trust-based relationships supplant the incomplete legal system, particularly in terms of enforcement. In this way, the complementary processes of legal, institutional and economic reform in China can explain the paradox of remarkable growth within an under-developed system of law.