Stock market in China's modernization Process Its past, present and future prospects Zhiwu Chen Yale School of management June 1. 2006 Chinas stock market today is of a sizable scale. It has 1377 listed companies, with a total market capitalization of RMB 3. 5 trillion(two thirds of which is not yet tradable) and a monthly trading volume of RMB 364 billion. There are over 300 securities and trust companies that are licensed to provide stock brokerage services through more than 2500 branch offices in cities, large and small. This extensive network of brokers has attracted more than 73 million stock trading accounts The 53 fund management companies offer hundreds of mutual funds that are distributed through the vast retail network of thousands of commercial bank branch offices. Together with the advanced electronic trading systems at both the Shanghai Stock Exchange and the Shenzhen Stock Exchange, China today has among the most robust securities market infrastructures in the world, when measured in terms of both trading capacity afforded by the advanced electronic systems and potential investor each facilitated by the vast physical distribution network. The physical infrastructure and distribution network present the Chinese economy with a great financing potential The gap between potential and reality is, however, still quite large. While Chinas physical infrastructure for a stock market is impressive by many measures, the institutional Professor of Finance, Yale School of Management, New Haven, CT 06520 Zhiwu chen@vale. edu The author would like to thank william Goetzmann for the many conversations on this topic and Wei XIONG and other participants at the China Industry Conference at Yale, April 2006. Any remaining errors are the authors responsibility alone I The statistics cited in this paragraph are all as of February 2006. Source: The Chinese Securities RegulatoryCommissionwww.csrc.gov.cn
Stock Market in China’s Modernization Process ---- Its past, present and future prospects Zhiwu Chen ∗ Yale School of Management June 1, 2006 China’s stock market today is of a sizable scale. It has 1377 listed companies, with a total market capitalization of RMB 3.5 trillion (two thirds of which is not yet tradable) and a monthly trading volume of RMB 364 billion. 1 There are over 300 securities and trust companies that are licensed to provide stock brokerage services through more than 2500 branch offices in cities, large and small. This extensive network of brokers has attracted more than 73 million stock trading accounts. The 53 fund management companies offer hundreds of mutual funds that are distributed through the vast retail network of thousands of commercial bank branch offices. Together with the advanced electronic trading systems at both the Shanghai Stock Exchange and the Shenzhen Stock Exchange, China today has among the most robust securities market infrastructures in the world, when measured in terms of both trading capacity afforded by the advanced electronic systems and potential investor reach facilitated by the vast physical distribution network. The physical infrastructure and distribution network present the Chinese economy with a great financing potential. The gap between potential and reality is, however, still quite large. While China’s physical infrastructure for a stock market is impressive by many measures, the institutional ∗ Professor of Finance, Yale School of Management, New Haven, CT 06520. Zhiwu.chen@yale.edu . The author would like to thank William Goetzmann for the many conversations on this topic and Wei XIONG and other participants at the China Industry Conference at Yale, April 2006. Any remaining errors are the author’s responsibility alone. 1 The statistics cited in this paragraph are all as of February 2006. Source: The Chinese Securities Regulatory Commission, www.csrc.gov.cn. 1
frastructure necessary for financial market development is largely or not functioning in its intended way. As a result, for example, the Chinese stock market from October 2002 to March 2006 went down by 15%(the only down stock market around the globe over this period, as measured in U.S. dollar returns), even though Chinas GDP managed to grow by more than 9% year over year. To highlight the declining investor confidence in China's stock market. note that in 2005 each month brought in fewer than 100,000 new stock accounts, whereas in 2001 the monthly increase in investor accounts was more than 800.000. 3 Further deepening of Chinas stock market requires the development of a more acceptable institutional infrastructure, so that investors can be confident that the separation between ownership and control -- the heart of a public equity market -- will not mean the lack of protection for their hard-earned money. Such an infrastructure contains three key components:(i reliable and independent legal institutions, (ii) an independent regulatory body, and (iii) uninhibited informational institutions. The former two ensure that investors assets will be protected and that their interest will be maximized to the extent possible by management insiders(black 2001 and Coffee 2001). At the center of these two sets of institutions is the rule of law. The last component serves to provide investors with unbiased useful and substantial information so that they can reliably assess the value of each stock as an investment opportunIt As is known in the literature such impersonal external and checked-and-balanced institutions are what China has traditionally lacked and still lacks. In this sense, the search for a deep and liquid stock market is synonymous with Chinas process of modernization. Until the rule of law is a basic characteristic of the Chinese society it is hard to imagine that china will have a well developed stock market. A functioning constitutional system is a pre condition for a prosperous public equity market Over the last 150 years, China has engaged in a long march towards a modern society Scholars and policy makers in China have often identified modernity with the modernization of industry, of agriculture, of national defense, and of science and technology, that is, the so 2 See Norris(2006) SourceTheChineseSecuritiesRegulatoryCommissionwww.csrc.gov.cn
infrastructure necessary for financial market development is largely missing or not functioning in its intended way. As a result, for example, the Chinese stock market from October 2002 to March 2006 went down by 15% (the only down stock market around the globe over this period, as measured in U.S. dollar returns), 2 even though China’s GDP managed to grow by more than 9% year over year. To highlight the declining investor confidence in China’s stock market, note that in 2005 each month brought in fewer than 100,000 new stock accounts, whereas in 2001 the monthly increase in investor accounts was more than 800,000. 3 Further deepening of China’s stock market requires the development of a more acceptable institutional infrastructure, so that investors can be confident that the separation between ownership and control --- the heart of a public equity market --- will not mean the lack of protection for their hard-earned money. Such an infrastructure contains three key components: (i) reliable and independent legal institutions, (ii) an independent regulatory body, and (iii) uninhibited informational institutions. The former two ensure that investors’ assets will be protected and that their interest will be maximized to the extent possible by management insiders (Black 2001 and Coffee 2001). At the center of these two sets of institutions is the rule of law. The last component serves to provide investors with unbiased, useful and substantial information so that they can reliably assess the value of each stock as an investment opportunity. As is known in the literature, such impersonal external and checked-and-balanced institutions are what China has traditionally lacked and still lacks. In this sense, the search for a deep and liquid stock market is synonymous with China’s process of modernization. Until the rule of law is a basic characteristic of the Chinese society, it is hard to imagine that China will have a well developed stock market. A functioning constitutional system is a precondition for a prosperous public equity market. Over the last 150 years, China has engaged in a long march towards a modern society. Scholars and policy makers in China have often identified modernity with the modernization of industry, of agriculture, of national defense, and of science and technology, that is, the so 2 See Norris (2006). 3 Source: The Chinese Securities Regulatory Commission, www.csrc.gov.cn. 2
called"Four Modernizations". These Four modernizations have been a defining theme of social and political movements by generations of Chinese since the 1850s. As such, the development of impersonal legal institutions has often not been thought to be a crucial part of the modernization process. Consequently, not as much efforts have been spent on modernizing Chinas institutional infrastructure In this chapter, our purpose is to review the history of China's stock market development from the 1860s to the present and then make projections on its future path. In the discussions to follow, a central question that we attempt to answer is absent of the necessary impersonal legal and regulatory institutions, what functionally substitutive arrangements did China come up with to induce public investors to join stock trading? That is, what was done to overcome the confidence and trust barriers? How well have such functional substitutes worked in promoting capital market development? What we will see is a constant struggle between the traditional Chinese preferences for informal or relationship-based rules of business transactions and the stock markets dependence on formal structures of contracting and governance. This struggle in the capital market place mirrors closely the struggle by the larger Chinese society with the process of modernization. It has led to frequent disruptions and crashes in stock trading. Chinas stock market history thus reflects its modern social and political history. In the same sense, its future will also mirror the social and political future of China 1. The origin of china's stock market: 1860s to 1911 The word for"securities", ZhengQuan, came into the Chinese language in the 19 century when trading in stocks and bonds was first brought to Shanghai by foreigners in the 1860s. Initially, stocks were issued by foreign registered companies and traded mostly by non-Chinese residents in the treaty ports. Examples include the Shanghai Steam Navigation Company(started in 1862 by russell and Company)and hSBC(1865 by the British). It was in the early 1870s when the first indigenous joint-stock company -- The China merchants Steam Navigation Company(CMC, in short)--- was established and its shares were later traded informally on the Shanghai streets. Other domestic enterprises of the modern
called “Four Modernizations”. These Four Modernizations have been a defining theme of social and political movements by generations of Chinese since the 1850’s. As such, the development of impersonal legal institutions has often not been thought to be a crucial part of the modernization process. Consequently, not as much efforts have been spent on modernizing China’s institutional infrastructure. In this chapter, our purpose is to review the history of China’s stock market development from the 1860’s to the present and then make projections on its future path. In the discussions to follow, a central question that we attempt to answer is: absent of the necessary impersonal legal and regulatory institutions, what functionally substitutive arrangements did China come up with to induce public investors to join stock trading? That is, what was done to overcome the confidence and trust barriers? How well have such functional substitutes worked in promoting capital market development? What we will see is a constant struggle between the traditional Chinese preferences for informal or relationship-based rules of business transactions and the stock market’s dependence on formal structures of contracting and governance. This struggle in the capital market place mirrors closely the struggle by the larger Chinese society with the process of modernization. It has led to frequent disruptions and crashes in stock trading. China’s stock market history thus reflects its modern social and political history. In the same sense, its future will also mirror the social and political future of China. 1. The origin of China’s stock market: 1860’s to 1911 The word for “securities”, ZhengQuan, came into the Chinese language in the 19th century when trading in stocks and bonds was first brought to Shanghai by foreigners in the 1860’s. Initially, stocks were issued by foreign registered companies and traded mostly by non-Chinese residents in the treaty ports. Examples include the Shanghai Steam Navigation Company (started in 1862 by Russell and Company) and HSBC (1865 by the British). It was in the early 1870’s when the first indigenous joint-stock company --- The China Merchants’ Steam Navigation Company (CMC, in short) --- was established and its shares were later traded informally on the Shanghai streets. Other domestic enterprises of the modern 3
corporate form followed suit, including the Jiangnan Arsenal, the Shanghai Cotton and Textile Co., and the Kaiping Coal Mines, ventures that formed the original foundation of China's modern manufacturing and mining industries Stock trading was thus introduced into China around the same time period as stock exchanges were established in many other countries, including Switzerland(1850), Spain (1860), Hungary(1864), Turkey(1866), Australia(1871), Czechoslovakia(1871), Argentina (1872), New Zealand(1872), Canada(1874), Brazil(1877), India(1877), Norway(1881) South Africa (1887), Egypt(1890), Chile (1892), Greece (1892), Mexico (1894), and Singapore(1911). It coincided with the major stock market craze -- the railroad stock bubble ---in the 1860s and 1870s in the U.S. and England. China is known to be the first country that invented paper money dating back to the Song dynasty(960-1279). But, itdid not venture into innovations in securities trading until the late 19 century. still, globally speaking, China was not far behind in adopting this financial technology: tradable ownership shares. The question is then: what led to the adoption of the modern corporate form and its twin - stock trading China? How did this western financial innovation fit in China's political, legal and social traditions? China's venture into the stock market and its associated corporate form was largely consequence of the Self-Strengthening Movement following the defeat in both Opium Wars (1839-42 and 1858-60)to Britain and France(in the second Opium War). The wars taught th Chinese elite a lesson that China was far behind in military technology and that in order to win over the West and regain national pride, China must catch up with western military and industrial technologies. But, adopting such technologies and developing the necessary manufacturing infrastructure required much capital, large sums of capital. Yet, at the time the Qing government was financially constrained. The state would not have the needed resources to take on the projects directly. The financing challenge was therefore daunting Note that after losing the first Opium War in 1842, China signed the historical Nanking Treaty with Britain. As part of the agreement, China agreed to open five port cities See Table I of Goetzmann and Jorion(1999)for a more complete list of stock exchange starting times around the globe See von Glahn(2005)
corporate form followed suit, including the Jiangnan Arsenal, the Shanghai Cotton and Textile Co., and the Kaiping Coal Mines, ventures that formed the original foundation of China’s modern manufacturing and mining industries. Stock trading was thus introduced into China around the same time period as stock exchanges were established in many other countries, including Switzerland (1850), Spain (1860), Hungary (1864), Turkey (1866), Australia (1871), Czechoslovakia (1871), Argentina (1872), New Zealand (1872), Canada (1874), Brazil (1877), India (1877), Norway (1881), South Africa (1887), Egypt (1890), Chile (1892), Greece (1892), Mexico (1894), and Singapore (1911). 4 It coincided with the major stock market craze --- the railroad stock bubble --- in the 1860’s and 1870’s in the U.S. and England. China is known to be the first country that invented paper money dating back to the Song dynasty (960 – 1279).5 But, it did not venture into innovations in securities trading until the late 19th century. Still, globally speaking, China was not far behind in adopting this financial technology: tradable ownership shares. The question is then: what led to the adoption of the modern corporate form and its twin --- stock trading --- in China? How did this western financial innovation fit in China’s political, legal and social traditions? China’s venture into the stock market and its associated corporate form was largely a consequence of the Self-Strengthening Movement following the defeat in both Opium Wars (1839-42 and 1858-60) to Britain and France (in the second Opium War). The wars taught the Chinese elite a lesson that China was far behind in military technology and that in order to win over the West and regain national pride, China must catch up with western military and industrial technologies. But, adopting such technologies and developing the necessary manufacturing infrastructure required much capital, large sums of capital. Yet, at the time the Qing government was financially constrained. The state would not have the needed resources to take on the projects directly. The financing challenge was therefore daunting. Note that after losing the first Opium War in 1842, China signed the historical Nanking Treaty with Britain. As part of the agreement, China agreed to open five port cities 4 See Table 1 of Goetzmann and Jorion (1999) for a more complete list of stock exchange starting times around the globe. 5 See von Glahn (2005). 4
for foreign trade, including Shanghai, Guangzhou, Xiamen, Fuzhou and Ningbo. In the following two decades, British merchants and other nationals moved into the different foreign settlements or concessions in Shanghai. as noted above. in the 1860s. founders of several foreign-registered joint-stock corporations(such as HSBC, the Union Steam Navigation Co the Shanghai Steam Navigation Co., and Trautmann Co were able to raise capital by issuing publicly tradable shares to private investors. These examples of stock trading brought to Shanghai by westerners provided a timely idea to the on-going post-war debate in Ch at is, you can raise funds through issuing public shares to a large number of investors. It made many Chinese intellectuals and policy advisors conclude that industrial technology and financial technology are what allowed the West to be more powerful As one of the leading voices at the time, XUE Fucheng(1838-1894), commented, The essence of the joint-stock corporation is to make a nation rich and powerful .. If a country does not pursue joint-stock companies, its industry cannot prosper nor can its commerce:If Chinas industry and commerce do not prosper, China will not be rich nor powerful. "Where foreign firms are present, there are corporations raising capital from hundreds or even thousands of shareholders. Backed by plenty of financial resources, no wonder they are so powerful and hard to compete with. This is truly an unprecedented historical change in business. In 1868, an 1854 Yale College graduate(also the first Chinese student who ever graduated from an American university ) Yung Wing, proposed to the then governor-general of Liangjiang, ZENG Guofan, to adopt the joint-stock corporate form and start a Chinese-owned navigation company. That idea was well received by the Qing mandarins. China was thus on its way to experiment with the modern corporation and make its shares tradable. But, how could this be done? The modern corporation has three defining characters. First, it is a"legal person with the same ability to do business and engage in contracting as a real person. Second, it can issue tradable shares to any number of investors. Third, the investors face limited liability (i.e, they could lose no more than their initial investment). At the heart of the modern corporation is the separation between ownership and control, that is, thousands of outside 6 Quoted from page 271 in Li(2002)
for foreign trade, including Shanghai, Guangzhou, Xiamen, Fuzhou and Ningbo. In the following two decades, British merchants and other nationals moved into the different foreign settlements or concessions in Shanghai. As noted above, in the 1860’s, founders of several foreign-registered joint-stock corporations (such as HSBC, the Union Steam Navigation Co., the Shanghai Steam Navigation Co., and Trautmann & Co.) were able to raise capital by issuing publicly tradable shares to private investors. These examples of stock trading brought to Shanghai by westerners provided a timely idea to the on-going post-war debate in China, that is, you can raise funds through issuing public shares to a large number of investors. It made many Chinese intellectuals and policy advisors conclude that industrial technology and financial technology are what allowed the West to be more powerful. As one of the leading voices at the time, XUE Fucheng (1838-1894), commented, “The essence of the joint-stock corporation is to make a nation rich and powerful … If a country does not pursue joint-stock companies, its industry cannot prosper nor can its commerce; If China’s industry and commerce do not prosper, China will not be rich nor powerful.” “Where foreign firms are present, there are corporations raising capital from hundreds or even thousands of shareholders. Backed by plenty of financial resources, no wonder they are so powerful and hard to compete with … This is truly an unprecedented historical change in business.” 6 In 1868, an 1854 Yale College graduate (also the first Chinese student who ever graduated from an American university), Yung Wing, proposed to the then governor-general of Liangjiang, ZENG Guofan, to adopt the joint-stock corporate form and start a Chinese-owned navigation company. That idea was well received by the Qing mandarins. China was thus on its way to experiment with the modern corporation and make its shares tradable. But, how could this be done? The modern corporation has three defining characters. First, it is a “legal person”, with the same ability to do business and engage in contracting as a real person. Second, it can issue tradable shares to any number of investors. Third, the investors face limited liability (i.e., they could lose no more than their initial investment). At the heart of the modern corporation is the separation between ownership and control, that is, thousands of outside 6 Quoted from page 271 in Li (2002). 5
investors(owners)entrust their capital with the management who has actual and full control over the use of shareholder assets. To provide outside shareholders with the needed confidence, this separation has to be supported by a corresponding set of legal institutions including investor-friendly substantive laws, an independent judiciary and a reliable enforcement infrastructure(Black 2001 and Coffee 2001). In addition, as what is exchanged between the outside shareholders and the corporation is a financial contract (instead of tangible physical goods), there need to be informational institution a free other mass media. to facilitate the uninhibited and fast flow of information Substantial and ruthful information about the stock-issuing corporation is essential for the accurate pricing of its traded shares and for the keeping of investors'trust Business organizations and economic transactions in China had relied on personal elationships for centuries. Relationships served as a signaling and commitment framework or as informal bedrocks for trust and a basis for enforcement of contracts (implicit or explicit) Partnerships of unlimited liability were the typical form of joint ownership, with partners from a single family, a lineage, a small number of lineages, or the same locality, usually not going beyond township boundaries. Before the railroad network was built in the late 19 century and afterwards, the lack of mass transportation means prevented for centuries the inland local economies from expanding across regions, generating no pressure for business organizational changes. The waterways in south-east China (Jiangnan)and along the coast could have pressured the unlimited-liability partnership structure and called for more impersonal forms of business organization. However, the emperors' orders forbidding overseas trading since the 13 century and the general anti-commercial Chinese culture stifled the possibility of inter-regional market expansion afforded by the waterways There had nonetheless been a few successful partnership cases in which there wer not only clear separation between ownership and control, but also the ability to sustain growth for more than a century. According to Pomeranz (1997), the Yutang Pickle Factory was founded as a family business in 1779 and sold in 1807 to a partnership owned by several partners, of which the two main partners were from the Bing and the Sun lineages. From 1807 to 1905, the Bing and Sun families remained the controlling partners. After 1905, the Sun lineage bought out the Bing and other outside partners and became the sole owner of the
investors (owners) entrust their capital with the management who has actual and full control over the use of shareholder assets. To provide outside shareholders with the needed confidence, this separation has to be supported by a corresponding set of legal institutions, including investor-friendly substantive laws, an independent judiciary and a reliable enforcement infrastructure (Black 2001 and Coffee 2001). In addition, as what is exchanged between the outside shareholders and the corporation is a financial contract (instead of tangible physical goods), there need to be informational institutions, such as a free press and other mass media, to facilitate the uninhibited and fast flow of information. Substantial and truthful information about the stock-issuing corporation is essential for the accurate pricing of its traded shares and for the keeping of investors’ trust. Business organizations and economic transactions in China had relied on personal relationships for centuries. Relationships served as a signaling and commitment framework, or as informal bedrocks for trust and a basis for enforcement of contracts (implicit or explicit). Partnerships of unlimited liability were the typical form of joint ownership, with partners from a single family, a lineage, a small number of lineages, or the same locality, usually not going beyond township boundaries. Before the railroad network was built in the late 19th century and afterwards, the lack of mass transportation means prevented for centuries the inland local economies from expanding across regions, generating no pressure for business organizational changes. The waterways in south-east China (Jiangnan) and along the coast could have pressured the unlimited-liability partnership structure and called for more impersonal forms of business organization. However, the emperors’ orders forbidding overseas trading since the 13th century and the general anti-commercial Chinese culture stifled the possibility of inter-regional market expansion afforded by the waterways. There had nonetheless been a few successful partnership cases in which there were not only clear separation between ownership and control, but also the ability to sustain growth for more than a century. According to Pomeranz (1997), the Yutang Pickle Factory was founded as a family business in 1779 and sold in 1807 to a partnership owned by several partners, of which the two main partners were from the Bing and the Sun lineages. From 1807 to 1905, the Bing and Sun families remained the controlling partners. After 1905, the Sun lineage bought out the Bing and other outside partners and became the sole owner of the 6
company until 1956 when it was nationalized after the communist revolution. Throughout the 19century, the Bing and Sun families hired a professional manager for Yutang and kept the two controlling families at arms length distance from the daily management of the business This separation between ownership and control worked for almost a century from 1807 to 1905 As remarkable as it was, the Yutang Pickle Factory studied by Pomeranz(1997)was a rare exception, of course. However, this unique case was possible because the high politicallofficial positions held by the Sun and Bing families provided a functionally substitutive protection structure for property and contracts. For example, the Sun lineage had to send its children to study and take national exams, in order to become powerful officials Indeed, when Sun Yuting and Sun Shanbao joined the partnership to purchase the company in 1807, the former was already a Jinshi and a provincial governor-general, while the latter a Juren, which afforded him the opportunity to select among many official positions. In 1821 Sun Shanbao passed the exams to become a Jinshi, which resulted in his taking a high position in the Qing empire's bureaucracy as well. Several descendants of these two brothers also made it to high official positions in the late 19 century. In the absence of formal legal institutions run by the state and equally available to all citizens, such official positions held by members of the lineage served as effective functional substitutes to secure property contracts, and opportunities of business growth. Such an informal framework for property protection and contract enforcement was not based on a notion of rights, but on official power and brute force. This type of protection framework was not friendly to market development of a large scale or a wide scope. Neither was it conducive to the development of impersonal market-friendly legal institutions. Nonetheless, with such high official positions in the partners'families, Yutangs separation between ownership and control did not lead to the firms demise. The informal"gentlemen's agreement " among the partners and the manager was then possible to work and last for a century, because no one dared to"mess up with the
company until 1956 when it was nationalized after the communist revolution. Throughout the 19th century, the Bing and Sun families hired a professional manager for Yutang and kept the two controlling families at arm’s length distance from the daily management of the business. This separation between ownership and control worked for almost a century from 1807 to 1905. As remarkable as it was, the Yutang Pickle Factory studied by Pomeranz (1997) was a rare exception, of course. However, this unique case was possible because the high political/official positions held by the Sun and Bing families provided a functionally substitutive protection structure for property and contracts. For example, the Sun lineage had to send its children to study and take national exams, in order to become powerful officials. Indeed, when Sun Yuting and Sun Shanbao joined the partnership to purchase the company in 1807, the former was already a Jinshi and a provincial governor-general, while the latter a Juren, which afforded him the opportunity to select among many official positions. In 1821, Sun Shanbao passed the exams to become a Jinshi, which resulted in his taking a high position in the Qing empire’s bureaucracy as well. Several descendants of these two brothers also made it to high official positions in the late 19th century. In the absence of formal legal institutions run by the state and equally available to all citizens, such official positions held by members of the lineage served as effective functional substitutes to secure property, contracts, and opportunities of business growth. Such an informal framework for property protection and contract enforcement was not based on a notion of rights, but on official power and brute force. This type of protection framework was not friendly to market development of a large scale or a wide scope. Neither was it conducive to the development of impersonal market-friendly legal institutions. Nonetheless, with such high official positions in the partners’ families, Yutang’s separation between ownership and control did not lead to the firm’s demise. The informal “gentlemen’s agreement” among the partners and the manager was then possible to work and last for a century, because no one dared to “mess up” with the 7
families of official power,--- But, unfortunately, not everyone was so lucky to have official power in the family, which is why cases like Yutang's were rather rare in Chinese history According to Jensen and Meckling(1976)and Easterbrook and Fischel (1989), the modern corporation is simply a nexus of contracts"or a legal creation. For this"nexus of contractsto work, there have to be supportive laws and impartial enforcement institutions with enough force. But, as of the late 19th century, China did not have the necessary legal nor informational institutions for arm's-length or impersonal financial contracting, let alone an institutional infrastructure for public trading in financial contracts. First, in China's legal radition, the legal system is never separated from, or independent of, the administrative system(e.g, Jones(2003)for an excellent overview). At least since the tang dynasty(618- 906 A.D. )and until the end of the Qing in 191l, the system of government consisted of strong central authority headed by the emperor, who ruled through a bureaucracy and with absolute power. The lowest ranking officials at the county level represented the central government and in effect exercised all of the power of the state, even deciding lawsuit cases Adjudication was simply one of the many administrative duties. In addition, Chinas legal tradition put its emphasis on administrative and criminal sanctions, with a lack of formal development in contract, civil liability and procedural laws. For example, the great Qing Code was a collection of rules that were predominantly concerned with the official activities and functions of the bureaucracy, not with contractual disputes and relationships between and among private citizens. The imperial law touched upon private matters only as the matters were thought to affect imperial policies. Thus, the code was primarily of an administrative nature, and it tended to rely only on administrative and criminal penalties. This is in sharp contrast with the roman law tradition. from which western laws are derived. As Jones commented, In China, the subject matter of Roman civil law was considered only when it affected the interests of the Emperor"(Jones, 2003, p. 13). Rules and practices did not To contrast with the Yutang Pickle Factory case, Goetzmann and Koll (2004)provide an interesting, but more typical, case of Dasheng cotton mills, a family of modern enterprises initially founded by Zhang Jian(1853-1926). They conduct a careful study of how the Dasheng cotton mills were governed even after Zhang Jian took advantage of the first Company Law of 1904 and obtained limited-liability corporation status for his enterprises. Their study shows that even after the turn of the century living nd working with the modern corporate form had not become a second nature
families of official power. --- But, unfortunately, not everyone was so lucky to have official power in the family, which is why cases like Yutang’s were rather rare in Chinese history.7 According to Jensen and Meckling (1976) and Easterbrook and Fischel (1989), the modern corporation is simply a “nexus of contracts” or a legal creation. For this “nexus of contracts” to work, there have to be supportive laws and impartial enforcement institutions with enough force. But, as of the late 19th century, China did not have the necessary legal nor informational institutions for arm’s-length or impersonal financial contracting, let alone an institutional infrastructure for public trading in financial contracts. First, in China's legal tradition, the legal system is never separated from, or independent of, the administrative system (e.g, Jones (2003) for an excellent overview). At least since the Tang dynasty (618- 906 A.D.) and until the end of the Qing in 1911, the system of government consisted of a strong central authority headed by the emperor, who ruled through a bureaucracy and with absolute power. The lowest ranking officials at the county level represented the central government and in effect exercised all of the power of the state, even deciding lawsuit cases. Adjudication was simply one of the many administrative duties. In addition, China’s legal tradition put its emphasis on administrative and criminal sanctions, with a lack of formal development in contract, civil liability and procedural laws. For example, the Great Qing Code was a collection of rules that were predominantly concerned with the official activities and functions of the bureaucracy, not with contractual disputes and relationships between and among private citizens. The imperial law touched upon private matters only as the matters were thought to affect imperial policies. Thus, the code was primarily of an administrative nature, and it tended to rely only on administrative and criminal penalties. This is in sharp contrast with the Roman law tradition, from which western laws are derived. As Jones commented, "In China, the subject matter of Roman civil law was considered only when it affected the interests of the Emperor" (Jones, 2003, p. 13). Rules and practices did not 7 To contrast with the Yutang Pickle Factory case, Goetzmann and Koll (2004) provide an interesting, but more typical, case of Dasheng cotton mills, a family of modern enterprises initially founded by Zhang Jian (1853-1926). They conduct a careful study of how the Dasheng cotton mills were governed even after Zhang Jian took advantage of the first Company Law of 1904 and obtained limited-liability corporation status for his enterprises. Their study shows that even after the turn of the century living and working with the modern corporate form had not become a second nature. 8
develop to enforce impersonal contracts or commercial transactions, nor to protect property rights, across regions and beyond local circles A related barrier to China' s adoption of the modern corporation was its traditional practice of unlimited liability. Chinese literature classics are often full of stories in which children were held responsible for their parents' or even grand parents' unpaid debt, stories of debt being passed down generation after generation. This culture of unlimited liability is even dominant in today's Chinese society. But, limited liability is a fundamental character of the modern corporation, without which passive outside shareholders would not be willing to part with the control of their corporate assets and without which the inside managers would not want to engage in the control because they would not be willing to risk the future of their children and children's children. This is why a sage of the Progressive Era, Nicholas Murray Butler, proclaimed that" The limited liability corporation is the greatest single discovery of modern times'"( Micklethwait and Wooldridge 2003, p. xXi). Therefore, the modern corporation would imply a direct clash with one of the defining features of the Chinese tradition Newspapers, commercial or otherwise, did not occur in China until 1861 when British merchants started the weekly in English, The Chinese Shipping List Advertiser In 1872, the first major newspaper in Chinese, Shen Bao, came into existence and had since played a fundamental role in nurturing a substantial readership in the following years. Thus, before the late 19th century, China did not have a sizable public media to facilitate the free flow of business information and hence reduce the level of informational asymmetry in the market place. According to Akerlof (1970) and Chen(2005), the level of information asymmetr between buyers and sellers cannot be too high especially when what is being traded is an intangible financial contract: Otherwise. trading in such markets would be difficult to last and a market shut-down would eventually occur Without the legal and informational institutions to support the separation between ownership and control, investors found it, not surprisingly, hard to have confidence in stock shares or to trust joint-stock corporations. As a high-ranking official and a key reformer, SHENG Xunhuai, informed the emperor in 1898,"The Imperial Railway Administration originally intended to depend on raising private capital. But Chinese merchants will only
develop to enforce impersonal contracts or commercial transactions, nor to protect property rights, across regions and beyond local circles. A related barrier to China’s adoption of the modern corporation was its traditional practice of unlimited liability. Chinese literature classics are often full of stories in which children were held responsible for their parents’ or even grand parents’ unpaid debt, stories of debt being passed down generation after generation. This culture of unlimited liability is even dominant in today’s Chinese society. But, limited liability is a fundamental character of the modern corporation, without which passive outside shareholders would not be willing to part with the control of their corporate assets and without which the inside managers would not want to engage in the control because they would not be willing to risk the future of their children and children’s children. This is why a sage of the Progressive Era, Nicholas Murray Butler, proclaimed that “The limited liability corporation is the greatest single discovery of modern times” (Micklethwait and Wooldridge 2003, p. xxi). Therefore, the modern corporation would imply a direct clash with one of the defining features of the Chinese tradition. Newspapers, commercial or otherwise, did not occur in China until 1861 when British merchants started the weekly in English, The Chinese Shipping List & Advertiser. In 1872, the first major newspaper in Chinese, ShenBao, came into existence and had since played a fundamental role in nurturing a substantial readership in the following years. Thus, before the late 19th century, China did not have a sizable public media to facilitate the free flow of business information and hence reduce the level of informational asymmetry in the market place. According to Akerlof (1970) and Chen (2005), the level of information asymmetry between buyers and sellers cannot be too high especially when what is being traded is an intangible financial contract; Otherwise, trading in such markets would be difficult to last and a market shut-down would eventually occur. Without the legal and informational institutions to support the separation between ownership and control, investors found it, not surprisingly, hard to have confidence in stock shares or to trust joint-stock corporations. As a high-ranking official and a key reformer, SHENG Xunhuai, informed the emperor in 1898, “The Imperial Railway Administration originally intended to depend on raising private capital. But Chinese merchants will only 9
come forward when the construction is completed and profits are visible . It is rarely heard that private merchants and common people buy stock. They may be attracted by a completed enterprise, but it is impossible to depend on them for new undertakings"(Feuerwerker 1958 p.237) Developing the necessary legal and informational institutions would by no means be a short-term task, even if the elite at the time had known how to do it. Given the urgency of Chinas modernization movement, the state had to come in and sponsor the new enterprises In the absence of a corporate law and a bankruptcy law, the governments sponsorship had to include implicit guarantees, limiting the liabilities for outside shareholders and for the corporation. This also marked the beginning of the state's role in corporate management and/or direct corporate ownership in modern Chinese history. Of course, other factors were important as well in the government s decision to become involved in the early experiment with joint-stock companies, including its traditional distrust in private merchants'motives(so the government had to be in, lest the businessmen would exploit the public). Also, the reformer officials were personally interested in ensuring the experiments success providing the new enterprises with privileged trade monopolies and protection from expropriation Take the CMC-the first modern corporation---as an example. It was founded in 1872 by LI Hongzhang in his official capacity as the governor-general of Zhili province and a key reformer official in the Qing court. In explaining his motive, Li stressed in a letter that The use of steamships for the transport of tribute rice by sea route is but a minor consideration. The project will open up new prospects for the dignity of the state, for commerce, for revenue, and for military strength of China for hundreds of years to come (Lai 1991, p. 142). In October 1872, he appointed ZhU Qi ang to be in charge of the CMc project and appropriated 135,000 taels of Zhili military funds as a government loan to the CMC. But, despite the government's sponsorship and assurance that outside shareholders would receive a 10% government-guaranteed dividend yield, private merchants pledged share capital of more than 100,000 taels but actually paid up only 10,000 in cash. Between 1873 and 1883, the government provided to the CMC annual loan amounts between 80,000 and
come forward when the construction is completed and profits are visible … It is rarely heard that private merchants and common people buy stock. They may be attracted by a completed enterprise, but it is impossible to depend on them for new undertakings” (Feuerwerker 1958, p. 237). Developing the necessary legal and informational institutions would by no means be a short-term task, even if the elite at the time had known how to do it. Given the urgency of China’s modernization movement, the state had to come in and sponsor the new enterprises. In the absence of a corporate law and a bankruptcy law, the government’s sponsorship had to include implicit guarantees, limiting the liabilities for outside shareholders and for the corporation. This also marked the beginning of the state’s role in corporate management and/or direct corporate ownership in modern Chinese history. Of course, other factors were important as well in the government’s decision to become involved in the early experiment with joint-stock companies, including its traditional distrust in private merchants’ motives (so the government had to be in, lest the businessmen would exploit the public). Also, the reformer officials were personally interested in ensuring the experiment’s success by providing the new enterprises with privileged trade monopolies and protection from expropriation. Take the CMC – the first modern corporation --- as an example. It was founded in 1872 by LI Hongzhang in his official capacity as the governor-general of Zhili province and a key reformer official in the Qing court. In explaining his motive, Li stressed in a letter that “The use of steamships for the transport of tribute rice by sea route is but a minor consideration. The project will open up new prospects for the dignity of the state, for commerce, for revenue, and for military strength of China for hundreds of years to come” (Lai 1991, p. 142). In October 1872, he appointed ZHU Qi’ang to be in charge of the CMC project and appropriated 135,000 taels of Zhili military funds as a government loan to the CMC. But, despite the government’s sponsorship and assurance that outside shareholders would receive a 10% government-guaranteed dividend yield, private merchants pledged share capital of more than 100,000 taels but actually paid up only 10,000 in cash. Between 1873 and 1883, the government provided to the CMC annual loan amounts between 80,000 and 10
