Has China Lost Its Way?: Getting Stuck in Transition

Saturday, July 1, 1995

If China is to become an economic superpower in the next century, financial markets will be essential to arbitrage risk. Such markets may fail to develop because of uncertainty over the role of government. Efficient financial markets will require that the Chinese Communist Party reduce its political leverage over economic decisions and decision makers.

Not every newly industrializing country has well-functioning liquid financial markets in which investors can diversify their risks. Nor do all developing countries have efficient legal systems in which a broad range of property rights can be enforced. China, for example, has experienced considerable growth without either liquid financial markets or an efficient legal system by using intermediaries--officeholders who construct broad exchange networks that are based on relationships rather than on formal institutions. The reputation of individual power brokers and the strength of their connection to party power centers provide the system's coherence. The capital requirements for future growth, however, may surpass the capability of these intermediaries, putting the system under severe strain. To overcome this strain, alternative methods of contracting agency relations that will require considerable elaboration of the legal system are needed. A rule- compliant, constitutionally grounded society and economy must be established so that contracts can be maintained independent of the personal authority of power holders. The danger of not acting is a liquidity crisis, intensified by the absence of institutions to reduce risks.