The Financial System Capacities in China and India∗

In this paper we examine and compare the formal systems of law and finance in China and India and the alternative institutional arrangements and governing mechanisms in the two countries, and the relation between the development of these systems and their economic growth. China differs from most of the countries studied in the law, institutions, finance, and growth literature: Its legal and financial systems as well as institutions are all underdeveloped, but its economy has been growing at a very fast rate. More importantly, the growth in the Private Sector, where applicable legal and financial mechanisms are arguably poorer than those in the State and Listed sectors, is much faster than that of the other sectors. The system of alternative mechanisms and institutions plays an important role in supporting the growth in the Private Sector, and they are good substitutes for standard corporate governance mechanisms and financing channels. Despite its English common-law origin and British-style judicial system and democratic government, there is enough documented evidence to suggest that the effective level of investor protection and the quality of legal institutions in India are quite weak as well. Once again, this has evidently not prohibited growth. We find that to a large extent Indian firms conduct business outside the formal legal system and do not rely on formal financin