Law and Economic Development in China: The Case of Stock Market

Growth

Dr. Zhong ZhangSchool of East Asian Studies

University of Sheffield

Outline

• Introduction • The growth history of China’s stock market• Legal developments• The role of law in the growth• The causality between law and market growth• Causes for market growth• Conclusion

Introduction

• Law and economic development – Optimists:

• Personal security; law and order; incentive for wealth creation (property law); facilitating commerce (contract law); limiting government power and bureaucracy; controlling corruption

– Sceptics: • What is the rule of law? which components are important

than the others?• Inconsistent empirical evidence • The direction of causality • Informal institutions• Failure to promote the rule of law

Introduction

• The experience of China– Sceptics

• “Little explanatory power”• “An important counterexample”• “Because of weak law”

– Optimists • Progress in the rule of law• Stages of economic development• “Middle income trap”• Strengthening the rule of law to sustain economic growth

Introduction

• The stock market of China

Introduction

Introduction

Introduction

• Questions– Is China a counterexample? Are investors not

concerned that their investment might be lost?– Is growth sustainable if law remains weak?– What cause/impede the improvement of law?– What can the experience tell about law and

economic development in China in general?

The history of growth• Before 90: emergence of shareholding system

and establishing the stock exchanges• 1st stage (90/01): rapid growth• 2nd stage (01/05): stock market in crisis• 3rd stage (06/09): boom, bust, stimulation• 4th stage (10/14): prolonged bear market

The history of growth• Stages of growth

The history of growth

The history of growth

Legal development • Before 1993: no national legislation; rudimentary local operational

rules; no specialized regulator; • 1993/2000: establishing the legal and regulatory framework

– Regulatory framework• 1992: CSRC • 1997: CSRC taking over control of the stock exchanges• 1999: centralisation and specialisation

– Major legislations: Company Law 1993; Provisional Regulations on Issuing and Trading Shares 1993; Securities Law 1998; Regulations on Stock exchanges 1996; criminal legislation (1995, 1997, 1999)

• 2001-: improvements – Legislation: CG Code 2001; Independent director 2001; company law 2005;

securities law 2005; criminal legislation 2005; Special regulations for minority shareholder protection 2004

– Enforcement: Inputs and outputs

The role of law• The first stage: irrelevant

– Rudimentary, in the process of establishment – Enforcement: few activities – Lawlessness: misappropriating corporate funds (737/1287);

false disclosure (72%), stock manipulation (80%)– “worse than a casino”; “a notoriously corrupt place”

• Why growth when law extraordinarily weak?– Behavioral explanation: bounded rationality – Time lag– Government bailouts– Lack of alternative investment opportunities

The role of law• The second stage (01/05): stock market in crisis

– Macro economy in best shape– Market performance: indices lost more than half; market cap/GDP: 48%-18%;

investor withdrawal (30%); IPO suspensions; the securities industry: in red for 4 years

– Bitter debates: “worse than a casino”; “scrap the old and build a new one from scratch”

• Why the crisis?– Bubble: P/E > 55– Corporate profitability: loss-making companies (19%); ROE: 14.68%-5.35% – Frauds (market manipulation, misappropriation, false disclosure) and scandals:

widespread (212); outrageous

• Weak law and the crisis– Weak law and corporate profitability – Weak law and frauds

The role of law• The third stage (06/09): market revival – The improvement of law: Crisis-forced

• Legislations• Investor protection indices: ADI: 3-5; ASDI: 0.76; SPI: 6th/20 • Enforcement

– Inputs: new enforcement units and branches; personnel: 32-600– Outputs: enforcement actions from single figure to over 100

• A degree of law and order: traditional market manipulation; misappropriation; false disclosure; insider trading

• “The most transparent and efficient market with the highest degree of rule of law in China”

– Market revival and the improvement of law

The role of law• The 4th stage (10/14): Prolonged bear market– Reasons

• Macro economy • Poor investment return: dividend yield: 0.75%, lowest; (1-year

deposit interest rate: 3.25%; risk-free rate of return: 5%)• Why?: low corporate profitability: ROA 5.58%, lower than 1-

year bank loan interest rate• Weak law and low corporate profitability

– The dominance of SOEs: 47%; 90%; 86%; 74%– Poor corporate governance of SOEs: corruption, waste, over-

investment and mismanagement– Law is weak

The role of law

• Summary – Law was indeed insignificant in the first stage– But weak law eventually led to crisis– Market revived, after investor protection

strengthened and a degree law and order established– Weak law: one reason for the post-2010 bear market

• The role of law: critical to sustaining market growth

Law and growth: The causality• Growthlaw: growth first followed by Law

– Growth without law: the first stage– Growthlaw:

• Investors: a powerful political constituency• The importance of stock market after growth: economic and

political

• Growthlaw– Law remains weak in the governance of SOEs– Why?

• Dominance of State ownership : political and ideological restriction• Private enforcement and the court: useless• The macro legal environment

Market growth/lack of it: The causes • Liberalization: ideological, political and economic• Economic growth: demand for and supply of capital • Other factors

– Alternative investment opportunities– SOE dominance – SOE monopoly/oligopoly: finance, mining, energy,

telecommunication – Business environment: bureaucracy and cost (96th/189,

158th, 185th, 120th)– Lack of technology, brand names, innovation: Apple vs.

Foxconn

Conclusion

• China is not a counter-example• Bidirectional causal relation between law and

market growth and law first followed by law• But the virtuous circle of “growth-law-further

growth” is not a guarantee • The first-order causes: liberalisation and

economic development • Policy implications: political and economic

liberalisation

Conclusion

• What can the experience of stock market development tell about law and economic development in general?– Law is necessary for sustaining economic growth – Law is a result of economic growth – But economic growth does not always lead to the

improvement law– Ideological, political and economic liberalisation is

fundamental