Governance and Foreign Investment in China, India, and Taiwan: Credibility, Flexibility, and International Business

Chapter 5. Unbundling the Rule of Law in China: Local Lawmaking Power and Private Investment

103 Chapter 5 Unbundling the Rule of Law in China Local Lawmaking Power and Private Investment There is consensus among economists and political scientists that economic growth requires a legal system that offers secure property rights and the enforcement of contracts (North 1990). Protection of property rights, shaping the relationship between the state and citizens, affects investors’ incentive for raising capital. Contracts enforcement, which affects the dynamics of private transactions, determines the efficiency of capital allocation (Acemoglu and Johnson 2005). In the absence of well-­ functioning legal systems to constrain the state and facilitate private transactions, countries will not be able to obtain sufficient long-­ term capital investments to support rapid economic growth. China’s experience provides an interesting case. As impressive as its rapid economic growth has been, China’s legal development, particularly in the business realm, has been phenomenal over the past 30 years. The strong correlation between the economic growth and legal development suggests that a better legal system is conducive to economic development. Just as a half-­ full glass is also half empty, China’s story could also contradict this belief. China is growing fast, yet its legal system, given the lack of independent legislatures and jurisdiction, has nothing that most Westerners would recognize as a rule-­ of-­ law tradition. Extensive legislative enactment accompanied by poor enforcement may even empower officials to engage in rent-­ seeking behaviors and may exacerbate a flawed legal system. Indeed, China is one of the largest recipients of foreign direct investment (FDI), but foreign firms seem to have little interest in the rule of law “beyond the immediate boundaries of their commercial interest” (Kine 2009). 104 governance and foreign investment in china, india, and Taiwan The scholarly literature notes that despite profound developments, China’s legal system is still constrained by the fundamental goal of maintaining party control, so it does not provide a secure system of property rights (e.g., Clarke et al. 2008; Alford 2003; Peerenboom 2002; Lubman 2000). As a policy apparatus, however, the legal system is effective in regulating government intervention and improving economic transactions, thus creating an environment conducive to foreign investment. Put simply, China’s overall economic development has less to do with formal legal institutions that check rulers and more to do with the political will behind the country’s legal development. Indeed, China’s legal development has been characterized by enormous legislative enactments but inconsistent implementation and enforcement. These complicated features raise yet another question that needs to be addressed as we assess the impact of the legal system on economic development. What does a formal legal system under an authoritarian framework really mean to foreign and domestic private investors? This chapter has a twofold argument. First, the importance of legal systems on private investment in China depends on not only how credibly the rule of law is established but also how effectively the government can respond to the needs of economic actors. Second, legal institutions have different effects on foreign and domestic private investments. Foreign investors, given their larger-­ scale and the greater complexity of their businesses, are more motivated to seek protection and reduced transaction costs from legal systems. Domestic private investors, given their smaller business scales and extensive informal networks, will pay much less attention to formal legal rules. This chapter uses subnational-­ level quantitative evidence to assess the effects of the legal system on investment. It introduces an easily accessed, objective measure of local legal systems. Specifically, it measures two aspects of local legal environments: legislative responsiveness and discretion. Legislative responsiveness measures how active local governments use legal instruments to intervene in economic activity. Legislative discretion measures to what degree local governments use their discretionary authority to enact legal instruments. I use these indicators to provide new evidence about the importance of the legal system in affecting different types of investment. The findings indicate that local legislative authorities in China are not just “rubber stamps.” Differences in the exercise of local lawmaking power not only play a role in explaining the regional distribution of FDI but also have distinctive effects on foreign and domestic private investors. Provinces tend to have higher levels of Unbundling the Rule of Law in China 105 FDI when their lawmaking powers are used more actively and less arbitrarily. Domestic private investment, in contrast, tends to respond favorably to provinces in which governments are less active but more discretionary in their use of...