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1CapitalMarketsandLegalDevelopment:theChinaCaseByZhiwuChen*YaleSchoolofManagementSeptember12,2003AbstractRecentresearchestablishesasignificantpositivecorrelationbetweenlawandfinance(andhenceeconomicgrowth),re-startingadebateonthe“lawmatters”thesis.However,whichwaythecausalitygoesisstillnotclear.Thepurposeofthispaperistousetheon-goingreformexperienceofChina,especiallyitscapitalmarketexperience,toexaminethedirectionofcausality.First,weshowthatChina’srecentexperienceislargelyconsistentwithCoffee's(2001)crash-then-lawinterpretationofthiscorrelation.Indeed,itisthelargeandclearlydefinedconstituencyofinvestorsthathasbeenakeydrivingforcebehindmuchoftherecentlegalprogress.TherightsandeconomicinterestsofthisconstituencyhavefundamentallychallengedthetraditionalemphasisoftheChineselegalcultureonadministrativeandcriminalsanctions,butnotoncivillitigationlaw.Second,wecomparethedifferentcontributionstolegalchangemadebythestockmarketandtheconsumerproductmarkets.Wearguethatcapitalmarketsareperhapsthemostconducivetotheformationofapoliticallypowerfulconstituencyandhencemoreaggressivelegalchange,becauseof(1)thehigherdegreeofcommonalityamonginterestedpartiesand(2)immediatelymeasurableandtangibledamages.Thesetwocharacteristicsnotonlyallowinvestorstoidentifywitheachothermoreeasily,butalsocreateanidealbasisformoredebateinthemedia,whichinturnpromotesthedevelopmentofalegalculture.Keywords:lawandfinance,legalreform,shareholderrights,productliability,capitalmarketdevelopment,economicdevelopment.*ZhiwuChenisaProfessorofFinanceattheYaleSchoolofManagement,135ProspectStreet,NewHaven,CT06520,USA;zhiwu.chen@yale.edu.Theauthorwouldliketothanktheeditorforthisissue,BeltonFleisher,forhispatienceandencouragement,DonaldClarke,AndreiShleiferandSteveYunfortheircommentsandsuggestions,andSHIMinglei,WANGYonghua,XIONGPeng,SteveYun,andZHOUFengforhelpingwiththedataandcasecollection.Anyremainingerrorsaretheauthor'sresponsibilityalone.21.IntroductionAcentralthesisinthelawandeconomicsliteratureisthatlawmattersforeconomicandmarketdevelopment.Accordingtothisthesis,theexistenceofalegalsystemthatprotectscontractandpropertyrightsisapreconditionforeconomicdevelopmentbecause,withoutsuchasystem,thelackofcertaintyaboutwhowillstandtobenefitfromotherwisebeneficialtransactionsand/orinvestmentswillsimplyinhibitsuchtransactions;Or,iftheyoccur,thecostsofdoingsowillbeunacceptablyhigh(North1990).1Thus,absentofsuchalegalorder,marketscannotdevelopandeconomicgrowthwillstall.Recently,asequenceofprovocativeresearchbyLaPorta,LopezdeSalines,ShleiferandVishny(1997,1998)(LLSVhereafter)hasshiftedthefocusofthelawmattersdebatetocapitalmarketdevelopmentissues.Usingalargedatabaseofvariousinstitutionalandeconomicvariablesforacrosssectionofcountries,LLSVshowthatthedegreeofprotectionacountry'ssubstantivelawprovidesforoutsideshareholders/security-holdershasasignificantbearingonthedepthandliquidityofitscapitalmarkets:strongerlegalprotectionforminorityshareholdersisassociatedwithdeeperandmoreliquidcapitalmarketsandwithlessconcentratedshareownership.2Ineffect,theyarguethatdeepcapitalmarketscannotbedevelopedunlessshareholder-friendlyfundamentallegalreformsareadoptedasaprecondition.Aconsensusintheliteratureisthatlawclearlymattersformarketdevelopment,especiallyafteramarketreachescertainmaturestage.Market-friendlylawisadesirablegood.But,howdoesacountrygettothatpoint?Howdoeslegalchangearisetoprepareforsustainedgrowth?----Whilenotquestioningthecorrelationbetweencapitalmarketdepthandlegalprotectionforshareholderrights,Coffee(2001)offerstheoppositeinterpretationoftheabovecorrelation:marketdevelopmentprecedes,ratherthanfollows,shareholder-friendlylegalreforms.Hisargumentisbasedonthehistoricalfactthat1SeeClarke(2003)foradiscussionofthepropertyrightsmatterthesisbasedonrecentexperienceinChina.2SeeShleiferandVishny(1997)foracomprehensivesurvey,andOhnesorge(2003thisissue)fordiscussionsonhowthisliteraturemaybenefitfromtherecentexperienceofChina.TheLawmattersthesisforsecuritiesmarketdevelopmenthaspromptedmuchnewresearchanddebateinlawandeconomics.ResponsesandhypothesesfromthelawliteratureincludeBlack(2001),Cheffins(2001),andCoffee(2001).3Althoughsecuritiesexchangeshaveexistedsincetheseventeenthcentury,exchangesprimarilytradeddebtsecuritiesupuntilthemid-nineteenthcentury.Then,overarelativelybriefperiodandatatimewhentheprivatebenefitsofcontrolwereunquestionablyhigh,dispersedownershiparoseinboththeUnitedStatesandtheUnitedKingdom-largelyintheabsenceofstronglegalprotectionsforminorityshareholders,whichcameafterward.Coffeefurthercommentsthatthissequencemakesobviouspoliticalsense:Legalreformsareenactedatthebehestofamotivatedconstituencythatwillbeprotected(oratleastperceivesthatitwillbeprotected)bytheproposedreforms.Hence,theconstituency(here,dispersedpublicshareholders)mustfirstarisebeforeitcanbecomeaneffectivelobbyingforceandaninstrumentoflegalchange.Twoquestionsthencometomind.First,howdoessuchaconstituencyariseinamarketgrowthprocess?Second,whichtypesofmarketoreconomicactivityaremoreconducivetolegaldevelopment?Inabroa