China’s Law, Finance, and Economic Growth Nexus

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Table of Contents

Abstract
Introduction
Reflection on the financial/economic phenomenon in China
Suggestions for future reforms on protection of minority shareholders
Conclusion
References

Abstract

The paper examines the nexus among the law, finance, and economic growth with the three different sectors in China. The economic development of the State sector, private sector, and listed sector will be analyzed. Through the empirical crisis, the findings reveal that the legal standards that influence countries’ financial development depict a large-scale difference between the situation in China and that of other countries.

Introduction

Financial development is a major aspect that facilitates the economic growth of a country (Beck, Levine, & Loayza, 2000; Levine, 1997). LLVS stated that the law is the force that promotes economic growth and financial development (Beck, Demi-rguc-Kunt, & Levine, 2003; Beck, Demirguc-Kunt & Maksi-movic, 2004; LaPorta, Lopez-de-Silanes, Shleifer, & Vishny, 1998; Levine, 1998, 2003). La Porta et al. (1997, 1998) study the nexus between law and finance, and economic development where they shed light on the significance of legal institutions in determining the financial health of a country. The study from the Allen, Qian, and Qain (2005) investigates the Chinese legal institutions by using the legal indices as established by La Porta et al. (1998). The study finds that the Chinese system is synsemantic compared to LLVS’s sample countries. However, the informal sector has largely sustained the rapid growth of China’s economy where the formal legal system merely plays a marginal role.

The paper proceeds as follows. Section 2 describes and disputes the relationship between measures of the development of legal and political institutions and indicators of financial market development and economic growth. Besides providing the reflection of the status quo of China’s economic phenomenon aspect, section 3 offers recommendations that the country can establish to address the wanting legal protection of minority shareholders. Finally, Section 4 offers conclusive remarks.

The authors’ arguments concerning poor legal protection of minorities in China

The article, “Law, finance, and economic growth in China” by Allen et al. (2005), presents an important analysis of some peculiarities about the Chinese economy, which according to the authors, has defied the normal curve of economic growth. According to the article, law, institutions, and finance are overwhelmingly supported by the existing literature and evidence as key catalysts to the growth of the economy of any country (Allen et al., 2005).

However, China defies these facts. In the last few decades, the country has experienced exponential growth relative to any other nation, despite its pitiable legal protection of its minority shareholders and the prevailing meager financial and institutional systems in place as compared to other developing and developed countries (Clarke, 2006; Zou, H., Wong, Shum, Xiong, & Yan, 2008). Allen et al. (2005) introduce another aspect of “legal protection of the minority protection and outside investors” (p. 60) that determines the health of an economy such as China. I agree with the authors’ arguments that countries that demonstrate “poor legal protection of the minorities and outside investors have weak external markets and/or slowed/negative growth for firms that operate in them” (Allen et al., 2005, p. 59).

A country’s legal environment for the protection of minority shareholders and approaches in place to restrict the expropriation of minority shareholders play an important role in determining the extent and size of its capital markets (Deng, 2016). Currently, the status of minority shareholders in China is not well protected. It does not fit in the “western” notion of minority shareholder protection (Krisch & Kingsbury, 2006). The reasons for poor or weak minority protection in China can be attributed to the size of majority block holdings owned by the government in the major listed firms, low priority given towards minority shareholder interests by controllers, and the perception of the powerlessness of the minority shareholders (Chin, 2011). In addition, the country has inadequate legal and civil remedies to address issues of minority shareholders. It also has a weak authority of independent directors in the listed companies.

On the other hand, the authors’ findings concur with LLSV’s projections after comparing the Chinese outdoor markets and those of other upcoming nations. I agree with the finding that the country has an insignificant external market that is in line with its pitiable legal structures that do not safeguard minority shareholders (Allen & Gale, 2004). The banking sector of a country is very important in the economy. Without it, a country would be expected to lag behind other peers with better banking sector (Brandt & Rawski, 2008). The Chinese banking sector is dominated by four state-owned banking institutions, which enjoy protection from the state and whose financial position and other important aspects are shrouded in mystery or lack of transparency. For example, the four banks have some of the highest non-performing loans (NPL), which have resulted from questionable loans to State-owned enterprises (SOEs).

It is evident that other factors that have been discussed in the article in addition to the supporting literature concur with the peculiar situation of the minority protection (Allen et al., 2005). China has less investor protection, lower role of financial markets in raising funds at firms’ level, and lower engagement of the government in protecting the private sector. In terms of stock prices, I agree with Allen et al.’s (2005) observation that links the synchronous nature of these prices in developing nations such as China to the questionable minority shareholder safety and the unsatisfactory regulation of markets in the respective states that include China.

In addition, the stock exchange market is also less developed as compared to other countries that have been discussed (Bai, Liu, Lu, Song, & Zhang, 2004). Concisely, I agree with the arguments presented by the authors that China presents a unique case that does not emphasize the need to offer legal protection to its minority groups. Hence, economic growth is not entirely tied to effective financial and legal frameworks, as witnessed in most other economies that are considered successful in both the developed and developing economies.

Reflection on the financial/economic phenomenon in China

The status of legal protection for the minority shareholders determines a country’s financial health, especially in its external markets. In the case of China, the vertical agency problem presents the main challenge that the minority shareholders face in the various listed firms. Currently, the major listed companies are controlled by the state. This situation leaves the minority shareholders with little or no say. Thus, it is apparent that China has infringed on their rights (Kroeber, 2016). Corporate governance in China is indeed a recent concept that can explain why the issue still dominates the concerns labeled against the listed companies in the nation (Wu, Xu, & Yuan, 2009).

For instance, the first Company Law was passed in 1994. Although much progress has been made on corporate governance, there is a long way to go before the country can attain the level of protection experienced in other developed economies such as USA and Europe. The authors use the existing literature on the key factors of economic growth such as stock prices and the economic law to support their arguments (Allen et al., 2005). In this case, the origin of the economic law of a country is an important indicator of its financial sector efficiency and success (Allen et al., 2005). For instance, according to the authors, countries that follow or whose legal and financial sectors are inspired by English common law seemingly have better institutions and less government corruption compared to those with French-inspired legal and financial systems (Allen et al., 2005).

The source of China’s poor legal protection of the minority investors becomes apparent since it upholds French-based legal and financial systems. In the former, the better legal protection and institutions lead to superior outcomes for the financial sector at the national and firm levels (LLVS, 2005). Indeed, this claim is valid based on the overwhelming support from other authors such as Allen and Qian (2015), Brandt and Rawski (2008), and Allen, Chakrabarti, De, Qian, and Qian (2007). They assert that countries whose legal and financial systems embrace English common law perform better and/or have higher integrity relative to those that uphold French or any other legal frameworks in the world.

As previously mentioned, corporate governance and protection of shareholders is a recent concept. The Company Law of 1994 was a major milestone, especially towards the protection of minority shareholders (Sheng, 2010). However, moving from theory and paper into implementation and action has been slow. For instance, while the Company Law of 1994 was a move to the right direction, it was majorly aimed at facilitating the conversion of SOEs into traded companies. However, minority shareholder rights were wither non-existent, unclear, or shrouded in contradictions and ambiguities.

In 2005, the country made a major progress towards the protection of minority shareholders when laws relating to the group were revised to introduce measures to protect their interests (Trautwein & Ying, 2013). These laws relate to the function of compensation and deterrence, as well as administrative regulations and stock exchange guidelines to address major corporate governance issues such as looting of listed companies by the controlling shareholders at the expense of minority shareholders.

Other major milestones include the 2013 Company Law, which provides minority shareholders with the right to be bought back, rights of winding up the company, and rights to bring derivative actions, which were previously non-existent (Hasan, Wachtel, & Zhou, 2009; Chen, Chen, & Wei, 2009). After 2005, it was possible for minority shareholders to undertake derivative actions against the directors, management, or other shareholders for failure in management. The Company Law of 2013 enhanced the powers of the board of supervisor. Specifically, the board was given powers to investigate and inspect financial affairs and operations if there were concerns over abnormalities (Lewis, 2013). In addition, the minority investors now have the powers to supervise the performance of the majority directors and managers and recommend their removal (Chen et al., 2009). Most importantly, they have the powers to convene shareholders’ meetings and bring legal actions against managers and directors.

Suggestions for future reforms on protection of minority shareholders

Addressing the problems of minority shareholder rights and protection in China requires various measures. The measures will ensure that the minority shareholders are well protected and confident about their investments and that the majority shareholders and the management can act in their best interests (Allen et al., 2005). Legal reforms and approaches can address the poor protection of minority shareholders in China. Firstly, China should uphold an ideal corporate governance situation that embraces transparency and access to factual and accurate information to all shareholders for decision-making purposes. Many investors and shareholders invest in companies with the understanding that those in charge or the controllers will act in the best interest for maximum benefit and returns to their investments (Deng, 2012).

If there is no good corporate governance, minority investors are likely to lose confidence in the company and hence withdraw their investments while on the other hand reducing the willingness of new shareholders to invest in such firms (Prud’homme & Song, 2016). Corporate agencies face two major problems, namely, vertical and horizontal bureau tribulations. Vertical agency problems arise between managers and shareholders where the managers may fail to act in the best interest of the shareholders (Deva, 2016). On the other hand, the horizontal agency problems arise when the majority shareholders have immense powers to the extent that they can influence their companies and/or often make decisions that do not necessarily have the best interests of the minority shareholders.

Secondly, in terms of legal measures, the enactment of the Company Law of 1994 and its subsequent amendment in 2005, and finally the Company Law of 2013 is a good example of how the law can be used to provide better protection to the minority shareholders (Allen et al., 2007). For the first time, the derivative action whose aim was to protect the interests of the company and minority shareholders was introduced. The law further provides guidelines for the organization of the internal structure of a company. It also coordinates the relationship between different entities in the company and hence the necessary protection to minority stakeholders.

Thirdly, despite the introduction of the derivative action protection, the hurdles against the minority investor are still very high (Chen, Firth, Gao, & Rui 2006). For instance, a very high burden of proof has been placed on the complaint, meaning that filing a case requires immense evidence that the minority shareholder may not have access to due to the power bestowed on the majority shareholders who refuse to release relevant information (Clarke, 2006). In addition, since the state manages most of the major listed companies, the government-steered bureaucracy and the judiciary sector makes the process of litigation costly for the minority shareholders (Rajagopalan & Zhang, 2008; Trautwein & Ying, 2013). Consequently, there is the need to lower the locus standi requirements while at the same time making the litigation procedures easier.

In addition, the boards of directors of companies are the strongest and weakest links to corporate governance (Twining, 2009). In the United States, the legal framework is very strong. It provides approaches for ensuring an independent board of directors, which can act for the best interest of all shareholders (Chen, 2014). On the contrary, the Chinese situation is weak. As such, majority shareholders can easily influence the board of directors at the expense of minority shareholders. Consequently, there is the need for the enactment or strengthening of the existing laws to give independence to boards of directors, thus ensuring increased protection for the minority shareholders.

Lastly, the current corporate governance structure in China allows the presence of a two-tier corporate governance structure (Allen & Gale, 2004). The structure comprises a board of directors and a supervisory panel. However, the mandate of the supervisory board is not well protected in the law. This situation limits its mandate, despite the fact that it has a major role to play in protecting the rights of the minorities (Krisch & Kingsbury, 2006). In this case, there is the need to clarify the mandate of the supervisory board in the law to give it a strong role as an overseer of the activities of the board of directors, thus protecting the rights of the minority shareholders.

Conclusion

The economic growth of China has defied the common script that places strong legal and financial frameworks as the basis of economic prosperity. Despite very poor financial sector characterized by state-owned banks with high levels of NPLs, corruption, and bureaucracy, the country has experienced very high economic growth. Therefore, following the western-like notion of economic growth is not the only way that a country’s economy can achieve prosperity. However, despite this growth, China faces a major problem where minority shareholders have little or no protection from the majority shareholders. The Company Law of 1994 was a step to the right direction.

However, it was mainly for facilitating the conversion of SOEs into publicly traded companies with little protection for minority shareholders. However, changes in 2005 and the Company Law of 2013 have led to major improvements in the protection of minority shareholders and hence a move to the right direction. Among the major milestones are the powers of minority shareholders to take derivative actions against directors, managers, and other shareholders. Consequently, the ability of the board of supervisors to demand accountability of directors, propose their removal, and/or convene shareholder meetings is an important milestone towards minority stakeholder protection in China.

References

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