Law, Development & Finance in Rising Powers

The aim of this project was to analyse to what extent the quality of legal and other formal institutions has affected financial development and economic growth in the BRIC countries, and whether reliance on informal institutions poses an obstacle to their future growth.

Methods

The project adopted an inter-disciplinary, multi-methods approach, combining quantitative analysis of the extent and nature of correlations between legal and financial development in the countries under review, with qualitative, fieldwork-based research aimed at building up a detailed, micro-institutional account of the perceptions and strategies of actors involved in legal and financial reforms. We used legal and financial datasets to carry out time-series and panel data analysis capable of specifying causal links between legal institutions and economic development in the rising powers and, by way of comparison, in a wider sample of developed and developing countries with over 30 annual observations per country. The fieldwork focused on the role played in each country by the banking sector and capital markets as alternative (or possibly complementary) sources of finance for firms; on how government reconciles or combines its continuing role as owner of financial and industrial enterprise with its emerging role as regulator of banks and securities markets; and on how firms meet their financing needs.

Results and dissemination

We constructed new indices of shareholder rights and creditor rights in 30 countries over the period 1990-2013. These new datasets enabled us to measure the global diffusion of laws for the protection of investors and creditors, and to estimate their effects on stock market and credit market development. While the impact of legal convergence was mediated by country-specific effects including local laws and institutions, we did observe some common trends. A key finding is that the strengthening of shareholder rights is associated with a rise in equity values and with with increases in stock trading but not in the number of listed companies. Thus a provisional conclusion is that enacting shareholder rights may not be enough on its own to create deeper and more liquid capital markets in developing economies.

We supplemented our econometric work with fieldwork in the four BRIC countries. Each country has a distinct experience but again there are some common trends.  

In China our fieldwork led us to be sceptical of the claim that China's recent economic growth is mainly the result of guanxi or interpersonal trust coupled with strong direction from central government. Instead we find increasingly sophisticated use of contracts and growing demand for the rule of law. There is less reliance on guanxi in product markets, in particular in the more economically advanced regions and in developing sectors such as IT. 

However, the move towards market-based transacting and transparent pricing is less evident in the case of Chinese financial markets. Chinese stock markets are not regarded as transparent and are dominated by state-owned enterprises. They do not yet provide a reliable source of equity finance for private-sector firms. Start-ups in sectors such as IT tend to rely on family members and angel investors for funding, rather than venture capital or IPOs. However, some of our interviewees expected Chinese stock markets to become more transparent over time.

In Russia we observed a somewhat different picture: there is pent-up demand for the rule of law but less confidence in the legal system, a stronger perception of judicial corruption, and more concern over a 'predatory' state, than in China. At the same time there has been a discernible change in the business environment in Russia since the turbulence of the 1990s. Medium-sized businesses can generally operate successfully as long as they stay 'below the radar' of state officials.  

A theme emerging from the Russian research is that western laws and practices cannot be simply imposed in the transition to a market economy. Entrepreneurial freedom and a reduced role for the state do not automatically translate into economic development, but may create the conditions for opportunism and abuse of power. The absence of democratic institutions may undermine otherwise sophisticated market-orientated laws.

The experiences of Brazil and India, both democracies, make for a relevant contrast. In both cases we observe positive effects of legal and corporate governance reforms aimed at promoting transparency in stock markets and encouraging bank-based lending to private sector firms. At the same time, larger enterprises play an important role in the stock market and in the economy as a whole, and convergence on a western model of deep and liquid capital markets is a gradual process.