Legal Informality and Human Capital Development in China

Abstract

China is often cited as a counterexample to the hypothesis that economic growth needs the support of certain basic legal institutions, such as strong protection of property rights and legal enforcement of contracts. The widespread legal informality in contracts among SOEs and in the way government has carried out regulation supports the claim that China in fact has lacked such growth-supporting legal institutions. Indeed, such legal informality may even have contributed to China’s economic growth by reducing transaction costs in contracts and administrative costs in government regulation. Correlation between legal informality and economic growth is not, however, the same as causation. Even if we could establish that such informality was an effective engine of China’s economic growth over the past three decades, past success does not guarantee anything for the future. China has changed as a result of economic growth. The range of actors involved in the Chinese economy and the stakes involved have dramatically increased. The state can no longer internalize the potential losses resulting from legal informality. The nature of potential risks and consequences of decisions made by market players and regulators have become more complicated. This complexity necessitates higher-quality information and more sophisticated skills for risk assessment and management. Under these new circumstances, legal informality is increasingly likely to generate decisions that do not fully incorporate associated risks or reflect necessary risk-control measures. Continued reliance on informality fails to provide sufficient incentives to individuals to acquire the information and skills required to assess and to manage risks involved in contracts and regulation. Individuals operating in such legal informality may resist reforms that would lead toward more rule-based and reason-based legal institutions because they are short of skills that are required in such a new regime. Executives of SOEs, legal professionals, and regulatory officials may be particularly likely to suffer in continued legal informality because they currently do not have enough incentives to develop the skills in dealing with complicated risks in the market. In a more developed and naturally complicated economy, legal informality is not only ineffective and inefficient, but also detrimental to those individuals at the center of legal institutions. The rest of this chapter is organized as follows. Section I introduces the concept of “legal informality” in the context of China’s legal development over the past three decades. Section II uses two examples to explain the legal informality in contracts among SOEs: (1) sales of non-performing loans (NPLs) by state-owned banks to state-owned financial asset management companies (AMCs), and (2) advances of loans by state-owned banks to the government’s land-stock authorities (LSAs) secured with land-stock mortgage (LSM). Section III illustrates informality in regulation, using the example of the regulatory approval process for initial public offerings (IPOs) in mainland China and Hong Kong. Section IV explains the potential cost-saving function of legal informality. Section V demonstrates the harm of legal informality in China’s new stage of economic development. A brief Conclusion follows, with comparison to the evolution of administrative systems in Japan in the twentieth century.