RISK MANAGEMENT
Scholar Warns of Weakness Beneath the Surface
January 31, 2007
Christopher Bjorke, AFP

“The assumption that China’s just going to grow indefinitely at a phenomenal rate is almost bound to be wrong based on historical experience.” ARTICLE TOOLS Print Version Reprints RECENT ARTICLES Different cities, same customers China is the region's top stop for exporting Improving wire transfers Quantifying your banks' performance

Scholar's book warns that problems in China’s legal and financial systems could undermine the country's economic growth.

China's industrial growth has been remarkable, but in many ways it has been built on a shaky, inefficient system inherited from its Maoist past. Could institutional weaknesses in areas such as rule of law, property rights and financial markets hold back the country's growth?

Kenneth W. Dam, a Brookings Institution scholar and former U.S. deputy secretary of Treasury and State, has written a book examining China's societal institutions and their possible effects on China's emergence as a world economic power. His recent book, The Law-Growth Nexus, explores the relationship between economic development and the development of the rule of law, the judiciary and financial markets.

In a recent presentation for Brookings, Dam cited weaknesses in corporate governance, judiciary independence and efficiency in financial markets as possible threats to China's growth. He spoke with ChinaForum.com.

What do you see as China's institutional weaknesses?

I think the judiciary lacks independence in a very fundamental way. It's partly structural in the sense that they are heavily beholden to the local party officials. They don't have any way of appealing to an inter-provincial court, such as exists in many other countries, like the United States, where there's an intermediate court between the lower court and the highest court that covers more than one territory.

I think that property rights are a problem particularly for agricultural land. As cities expand, the local farmers don't have any protection as a practical matter. The local party officials often have a financial interest in these land-use issues. A fundamental weakness is the fact that the party is still pretty autonomous. They're not subject to control by the courts, by other party organs, unless it's such a huge issue that it goes up the line to the central party.

How big of a concern are the Chinese banking and financial systems?

Here is the fundamental issue as I see it. They have a problem of transition. I don't think it's a lack of will or interest by the central government. They have all these state-owned industries. The state-owned industries employ a tremendous number of people. They have difficulty financing these industries because they're inefficient. Despite the fact that there are shortages of credit and other things for the private sector, it's been growing rapidly and taking over in many areas from the state-owned industries.

It's been a problem to finance state-owned industries, so their first solution was to sell stock, and apparently the Chinese viewed it as a kind of gambling den. An official wrote that it was a casino without rules. The stock market is booming right now for the first time. It was basically going down from 2000 until last year. Now it's booming again, partly because of the tremendous publicity for the successful IPOs, which were in Hong Kong, of three of the four big commercial banks.

We still don't have many private firms that have been able to sell stock and list. And so this transition from having a financial system designed to support the weakest firms, i.e. the state-owned firms, and not really available in a major way for the more efficient private firms, is a tremendous transitional problem, and it's going to be with China for a number of years.

So the corporate bond market basically doesn't exist. It's tiny, even compared to that part of Asia. This is a problem of financing for business.

I don't think it's going to cause a collapse, but I think it's a real barrier to rationalization of the economy and having a more efficient economy, especially as they become more and more dependent on domestic demand and not exports.

How do you think China could strengthen its institutions?

I think that these inefficiencies in the judicial system, in the system of financing state-owned industries, in the state-owned industries themselves-all of these things have to be worked on to become a more normal country from an economic point of view.

But I'm not predicting there's going to be a collapse or even a big slowdown. I'm just saying this is the risk, this tendency of people to extrapolate into the future indefinitely. That's almost always a mistake. It's been a mistake in the United States, the Internet boom and so forth. So that's what I see as the greater problem, the assumption that China's just going to grow indefinitely at a phenomenal rate is almost bound to be wrong based on historical experience.

Will independent institutions need some time before they take root?

I think this raises a fundamental issue of whether institutions have to improve first or whether the growth itself will lead to better institutions.

I give in my book the example of the U.S. securities market. We had a huge securities market before we got regulation to assure shareholders they were being told the truth and so forth. And one interpretation of that is that as you get wealthier, and you have more centers of wealth and financial power, they will demand protection against misrepresentation and fraud and so forth.

They have to train a judiciary. That takes time. That takes money, as well as good will. At first, a large percentage of judges were retired military officers, and there definitely was a view that the rule of law was about force and making people behave. But as you really need it for is the economy, you need trained judges that can handle complicated fact situations, and they're getting there but it takes time and resources devoted to it.

Editor's note:  Located in Washington, D.C., the Brookings Institution is a private nonprofit organization devoted to independent research and innovative policy solutions. The Law Growth Nexus is available through the bookstore.

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