Walter Hutchens’ Blog

The South China Morning Post has a story by Andrew Collier here concerning unofficial stock exchanges in China. Based on some information about such an exchange in Chengdu, it estimates the potential scale of such exchanges.

The story was posted on CLNET, and Knut Pissler in Germany asked, borrowing the title of an article by Don Clarke, “What’s law got to do with it?” He meant I think “how are we to understand the development of illegal PRC stock markets?” After all, securities exists only as a legal creation, so how can securities markets develop without the sanction of law?

China ’s essentially minor stock markets (official and unofficial) do invite one to theorize.

According to the SCMP story, the CSRC currently has a laissez faire attitude towards illegal exchanges. But this seems like a thin basis for turning money over to someone in exchange for intangible “legal rights.”

Since this is going on, one might conclude that you don’t need legally enforceable property rights to develop stock markets. Don Clarke has in fact challenged in a recent article the “rights hypothesis” of new institutional economics, at least with respect to third party enforcement of contract rights being essential to economic development, using China as the example.

One might also explore how social norms regulate markets in a way unsynchronized with legal texts. If the CSRC, local governments and investors are acting in ways that legitimize these markets (or at least creates a sense that the risks are tolerable given the alternatives), then this joint action creates “imagined markets” through social norms rather than NPC-adopted texts. One might compare how this relates to the historical development of securities markets elsewhere and what it says generally about the evolving status of the rule of law in China. The phenomenon of illegal stock markets may suggest, as Don argues generally, that market development can get pretty far simply with an expectation that government will not confiscate, even if you don’t have more developed enforcement of rights.

But to pronounce NIE ideas kaput (or refine them), one must take account of special PRC factors. Investors in China do not decide between investing in unofficial exchanges or buying shares of Microsoft. The could put their money in the bank at low interest rates, buy national bonds at low interest rates, lend to a cousin, go into business directly or buy securities on the official exchanges which have not seen a major bull market for years. Choices are few and each has risks. Putting money into unofficial shares has to be contextualized into this environment of severely limited choice.

Also, the role of the state in PRC securities markets is important. The state in China does more than just to officially sanction and enforce property rights shaped by private ordering. The state is the main issuer and regulator. Thus, an expectation that the state will not confiscate (including on a local, “unofficial” level) may count for more than it would in other contexts.

Moreover, in practice shareholders in the nationally sanctioned markets have pretty anemic rights against a miscreant issuer or trader. There may be less danger of a crack down closing the whole exchange, but where are the robust rights of PRC shareholders in the official exchanges? Usually they are just minority shareholders in corporatized SOEs, and even nearly a year after the SPC’s rules on private securities litigation (and four years after the Securities Law), I don’t know of any case in which a judge has awarded relief to defrauded investors after a trial.

And even taking all that into account, there is a scalability limitation to unofficial markets, as the article notes. I don’t think one will see China ’s insurance companies, investment funds or the national social security funds Gao Xiqing now shepherds moving substantially into these unofficial markets. That limits domestic capital accumulation and allocation, not to mention the possibility of attracting international capital on an institutional scale. Plus, unofficial markets are marginal in comparison to the official markets, which are themselves marginal contributors to PRC corporate finance.

Thus, rather than showing you don’t need strong property rights for stock markets, China’s minor stock markets (official and unofficial) may indicate how essential property rights are for certain kinds of economic development.