Mid-term report Summary for “Law, finance, and economic growth in China”a) A cover letter of the paperDear editor,We would like to submit the enclosed manuscript entitled "Law, finance, and economic growth in China". Below are our responses to your submission questions.1. Title and the central theme of the articlePaper title: “Law, finance, and economic growth in China". This paper compares China’s formal systems of law and finance and governing mechanisms with other developed and emerging countries. And they find that Chins is an important counterexample to the findings in the law, institutions, finance, and growth literature. Neither its legal nor financial system is well developed, yet it has one of the fastest growing economies. After examining the Stated, Listed and Private Sectors, they find the Private Sector grows much faster than the others and provides most of the economy’s growth. The imbalance among the three sectors suggests that alternative financing channels and governance mechanisms, such as those based on reputation and relationships, support the growth of the Private Sector.2. The part addressed excellentI believe that four aspects of this manuscript will make it excellent. First, the title is very common, but the content is new to readers and researchers. Second, the structure framework is wonderful and clear. Third, Panel Data applies well in the paper. Final, the conclusion implies that there areimportant factors connecting law, institutions, finance, and growth not well understood. A better understanding of how these nonstandard mechanisms work to promote growth can shed light on optimal development paths not only for China, but also many other countries.3. Name, fax and email address of the corresponding authorAuthors: Franklin Allen, Jun Qian, Meijun QianTel.: +1215 898 3629-fax: +1215 573 2207E-mail address: allenf@ (F. Allen).Finally, this paper is original unpublished work and it has not been submitted to any other journal for reviews.Sincerely yours,b) The main conclusionRecently several related literature on law, institutions, finance, and economic growth have emerged in financial economics. However, China is different. This paper compares China’s formal systems of law and finance and the alternative institutional arrangements and governing mechanisms with other developed and emerging countries. And the authors examine the relation between the development of these systems and China’ economic growth. With one of the largest and fastest growing economies in the world, China differs from most of the countries studied in the law, institutions, finance, and growth literature, and is an important counterexample to the existingfindings: Its legal and financial systems as well as institutions are all underdeveloped, but its economy has been growing at a very fast rate. After examining three sectors of the Chinese economy, the law–finance–growth nexus established by the existing literature works well for the State and Listed sectors. With poor legal protection of minority and outside investors, (standard) external markets are weak, and the growth of these firms is slow or negative. However, the size, growth, and importance of these two sectors in the economy are dominated by those of the Private Sector. In spite of relatively poorer applicable legal protection and standard financing channels, the Private Sector has been growing much faster than the others and has been contributing to most of the economy’s growth. The system of alternative mechanisms and institutions, such as those based on reputation and relationships, plays an important role in supporting the growth in the Private Sector, and they are good substitutes for standard corporate governance mechanisms and financing channels.The results on the differences among the three sectors in China challenge the view supporting the law–finance–growth nexus. Moreover, the success of the Private Sector in China also challenges the view that property rights and the lack of government corruption are crucial in determining financial and economic outcomes. Although the results are based on China, similar ’substitutes’ based on reputation and relationships may be behind the successof other economies as well, including developed economies. At the same time the results have general implications: there are important factors connecting law, institutions, finance, and growth not well understood. A better understanding of how these nonstandard mechanisms work can still be researched in depth.c) Policy implications of the researchIn this paper the authors have already examined three sectors in the economy and find the Private Sector has been growing much faster than the others, contributing to most of the economic growth. Then what the government should do to continue promoting Private Sector growth? Besides, China has realized economic growth under weak legal and financial system, then if China can take actions to improve legal and financial system, can the economic grow faster? What the policy implies in the paper?I make the following policy recommendations in view of the current situation in China.1. Increase financial support and expand the funding sourcesIn this paper, I find local government plays an important role in the development of Private Sector. Alternative financial channels and governance mechanisms replace standard corporate mechanisms. To continue accelerating the development of the Private Sector, the government should increase financial and funding support and make the correspondingpreferential policies to support the Private Sector, as well as Stated and Listed Sector.2. Develop the local finance and private finance actively andsteadilyThe regions should actively promote more financial innovation strategy, making the operation of the financial system more closely with local economic development. Support from financial institutions promotes various SMEs in the regional economic development, thus contributing to regional employment and adding strong vitality to the local economic. Meanwhile, development and growth of SMEs have also increased the size of financial institutions, providing support for expanding business and creating basis conditions for increasing operating income.3. Relieve financial constraints and emphasize the role of market The government should regulate the development of financial institutions using market mechanisms, promote various financial institutions and financial intermediaries vigorously and increase the efficiency of financial system. Meanwhile government reduces government's financial intervention, strengthen the market mechanism and create the conditions for financial development through the financial system innovation.d) Methods, especially the empirical methods usedIn this paper, authors don’t apply lots of complex tests or models. I think themethods used are mainly two. Next I will list followed in detail.1. Comparative analysisI think one of the features in this paper is a large number of applications of comparative analysis. Authors use comparative analysis in Section2, 3, 4 and 5. When analyzing the legal and financial system, the authors don’t show the data of China only, but compare China with other developed countries in the western. Meanwhile, to make the paper more persuasive, the authors compare with other emerging countries next. When researching on the development of the three sectors, they list the data from 1996 to 2002, using historical comparison. Next, authors study on the different importance of the financing channels in the three sectors respectively. Finally, they focus on the Private Sector. For the firms, authors compare the annual return in the past five years and next three years, the ownership and financial channels when startup and current. If they apply lots of models and conduct many complex tests, we may not understand. This comparative analysis also makes the idea clear and simple.2. Empirical methodsIn this paper, empirical methods mainly concentrated on Section 4. The authors perform three different sets of empirical tests find similar results. Concrete empirical models are presented below.Method 1: “Synthetic firm” approachStep 1: Using the summary statistics from LLSV samples to create a “synthetic Firm” for each of the 33 countries. Each firm characteristic is equal to the median of the same variable. Following the same procedure, a synthetic firm is also created for China based on the information of 1,100+ firms.Step 2: Three OLS regressions are run on the 33 (LLSV countries)“synthetic” observations. The dependent variables in these tests are: (1) dividend/earnings ratio;(2) dividend/sales ratio; and, (3) Tobin’s Q (measured by market-to-book assets ratio). The independent variables are the same ones used in LLSV. Based on the results from each of the three regressions, we then conduct an out-of sample prediction for China using the estimated coefficients and variances.Step 3: Compare the “true” (observed) firm characteristics of the Chinese synthetic firm to those predicted values from Step 2, and see whether the true value falls in the boundaries of predicted values.Method 2: “Alpha” approach-utilizing the alpha notation from asset pricing modelsThere are two versions of this model: restricted and unrestricted, depending on whether we restrict the coefficients on each independent variable to be the same for Chinese firms and for firms in other countries.Method 2-1: Restricted ModelMethod 2-2: Unrestricted modelMethod 3: Firm level out-of-sample predictionAuthors also perform firm-level out-of-sample predictions, based on the regression results from LLSV. The results are similar to the above two methods. Method 3 can actually be proven to be mathematically identical to the unrestricted model in Methode) Data and sampleIn this paper, the authors have used masses of data and several samples. I will list the samples and data respectively. When I list the sample, I will introduce the sample and state where the sample be used in this paper. And when I list the data used, I will write where the data be used (located in which sections) and the purpose of the data in this paper, besides, if available, I will list the source of the data.Sample:LLSV sample Section 2 &Section4Levine sample Section2LLS sample Section 4DLLS sample Section 5A sample of firms listed and traded on SHSE andSection 4SZSEA sample including 17 firms: One from Shanghai,Section 5 three from Jiangsu Province, and 13 fromZhejiang ProvinceData is presented in the last.f) The part addressed excellent according to your personal view1. New topic choosingAs a student, I have no much understanding of academic papers. But when I see the title ” Law, finance, and economic growth in China” at first sight, I thought the authors want to do research that better legal system leads to better financial system and better system contributes to the economic growth in China. But when I see the abstract of the paper, I find the paper is different from what I thought before. It studies on a counterexample—China. It is very interesting to us. Usually normal conclusions often do not stimulate our interest in reading, but the conclusions that are not exactly normal attract our attention to read. This is what this long, may be longest paper attract our group members.2. Overall structure of the paper, especially Section 4 and Section 5How the authors think of analyzing the economic growth after finding the counterexample—China? This is what I always think. Why I can’t think of it? This paper combines qualitative analysis with quantitative analysis and link theory research to empirical research methods. By the analysis of three sectors, authors transfer the contradictions from China's overall economic growth to the Private Sector. Section 4 applies empirical tests to evidence on the Listed Sector. Section 5 demonstrates the cause of good development of Private Sector in detail. In Sector 5, authors don’t use empirical tests, but a combination of qualitative analysis and mathematical deduce.3. Panel-dataThis paper collects the financial data from 1174 firms during 1992-2000 period using panel-data model and compares with those studied in LLSV, using regression. Comparing with using only cross-section data or time-series data to analyze economic, Panel-data model data has many advantages. (1) A combination of cross-section variables and time-series variable can significantly reduce the problems caused by the missing and omitted variables. (2) Panel-data model usually provides a large number of data points to the researchers, which increases degrees of freedom and reduces the multicollinearity among explanatory variables. Thus it improves the effectiveness of econometric estimation. (3) Panel-data model can analyze the economic issues from many aspects.g) Main drawbacks1. Inherent problems in LLSV ModelLLSV Model produces a substantial body of empirical evidence that links the origin of a country’s legal system to the country’s institutions and financial and economic outcomes. One of the central results of this literature is that countries with English common-law origin (French civil law origin) provide the strongest (weakest) legal protection to both shareholders and creditors. However, the merits of the legal system cannot be judged simply by origin. Although the British’s law system provides a stable and honest dispute resolution, its legal system does not provide good protection for small investors most of the time in the early 20th century. It is the market that results in good substitutes such as self-regulation system for protection of the interests of investors. Therefore, when assessing a country's legal system, do not over-praise the value of English common-law. The conclusion that English common- law is more conducive to financial development and economic growth based on a limited number of law indicators derived from Law and Financial theory lacks a solid theoretical foundation.2. In different regions, the relationship performance and mechanisms between financial development and economic growth will be different, so error will occur when conducting the empirical tests in the same way.3. This paper chooses a large number of variables to compare legal andfinancial systems in China with those of other developed and emerging countries. However, whether these variables reflect the true level of China's legal and financial systems does not reach an accurate conclusion. Meanwhile, this paper examines China's legal, financial system and economic growth using theoretical analysis and empirical research. The quality of research and analysis depend on the data's reliability, completeness and timeliness to some degree. As a research, the data used in this paper mainly comes from the various types of Authority Statistical Yearbook. The data is reliable, but the time is too short, mostly concentrated in 2002, making data relatively few. Therefore other researchers can make full use of the following data to continue researching on the law, finance and economic growth further if possible.4. In Section 5 of this paper, the authors provide anecdotal and survey evidence on the Private Sector firms. They choose 17 firms (One firm is from suburban Shanghai, three are from Jiangsu province, and the remaining thirteen are from Zhejiang province). They draw the conclusion that the private firms develop well by the data concerning firms’ background, financing channels, profit and other related information. But there exists serious regional imbalance in China, high levels of economic development in eastern and low level of development in central and western regions. In the evaluation of the actual situation of China’s economic growth, they had betterselect the data of the firms in the eastern, central and western respectively to study the relation of law–finance–growth nexus.h) Further issues to be investigated according to your understanding1. Research on other economiesThe paper focus on China, but similar conclusions and suggestions can be used to other economies and countries. China is a counterexample to the finding in the law, institutions, finance and growth literature. However whether there exists another country similar to China is still an issue worthy of study. If such a country exists, that it grows fast under poor legal and financial system, what causes the economic growth in this country? Is there any difference between this country and China? Therefore, further research should be done on the other countries to draw further conclusions comparing with China.2. Whether economic growth can reaction to the legal and financialsystemAccording to the results mentioned in the paper, neither its legal nor financial system is well developed, yet it has one of the fastest growing economies. Does the economic growth reaction to the legal and financial system in the opposite direction, to improve the efficiency of the financial system, and strengthen China's legal system? If it can, what the mechanismwill be? And what role the government plays in the interactions of the three? The results have general implications: there are important factors connecting law, institutions, finance, and growth which are not well understood. So it deserves to be study on.3. Long-term and short-term effectsThe paper mainly collects the data in 2002. It is not convincing to illustrate the conclusions using only one year of data. In the short term, China can realize economic growth under poor legal and financial systems. But if in the long term, China cannot maintain this rate of growth, or trend, I think we cannot regard China as a counterexample. In this case, the situation in China is also consistent with the LLSV model. Therefore, exploration on China's legal, financial, and economic growth should choose a longer time period and analyze the long-term and short-term effects respectively.4. Specific advice and arrangementsIf the conclusions from paper are correct, what arrangements can speed up economic development? As the paper said, the success of the firm in the Private Sector depends crucially on the support from the local government. Whether the government should actively support Private Sector development as the local government? Alternative financing channels can support the growth of the Private Sector. Whether Government should increase financial support for emerging firms and industries and deepen development offinancial intermediation? So many questions should be solved next.。
