Finance Without Law: The Case of China

Abstract

Can there be a highly developed financial market without the legal protection of investors and creditors? The highly-influential law and finance literature is built on the assumption that legal protection is essential to the development of an impersonal financial market. This article investigates how two financial markets of trillions of dollars have developed extralegally in the past two decades risking regulatory enforcement and contract defaults. More specifically, I examine (1) how Chinese internet companies from Sina to Alibaba have designed contracts to circumvent the Chinese government’s ban on foreign capital in certain industries and (2) how Chinese entities and foreign investors contract out of China’s stringent regulations on the issuance of international bonds. These extralegal contracts incur significant legal uncertainties and are unlikely to be enforceable in Chinese courts. Nevertheless, numerous international investors have invested in China through such contracts, providing capital essential to the country’s economic growth over the past two decades. My research reveals that (1) the extralegality of both the internet and international bond markets originates from China’s struggle between development, which requires access to the international capital market, and control, which requires keeping both Chinese enterprises and foreign capital on a short leash; and (2) a combination of private and state reputation mechanisms sustains the above finance without law. Overall, the network of financial intermediaries that controls access to the international capital market, the industry-specific communities of Chinese entrepreneurs and corporations that need access to that market, and the Chinese state, which promotes stability and predictability in both markets despite their extralegal contractual basis, replaces judicial enforcement in supporting financial development of a remarkable duration and scale. The reputation mechanism mitigates but does not solve the problem of credible commitment from the Chinese government, whose balance of development and control is inherently political.