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1Harvard Asia QuarterlySpring 2003

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2Harvard Asia Quarterly

Spring 2003

HAQHAQ Editorial Staff

Editor in ChiefJongsoo Lee

Graduate School of Arts and Sciences

Executive EditorMelody Chu

Harvard Law School

Managing EditorLoretta Kim


Production EditorMelody Chu

Harvard Law School

Web EditorGiro Cavallo


Area EditorsJongsoo Lee, Central Asia

Graduate School of Arts and SciencesManjari Miller, China

Graduate School of Arts and SciencesDanny Ooi, Korea

Graduate School of Arts and SciencesLeif-Eric Easley, Japan

Graduate School of Arts and SciencesHolly Gayley, South Asia

Graduate School of Arts and SciencesAndy Eng, Southeast Asia


Events EditorThomas Tso Graduate School of Arts and Sciences

Associate EditorsHarvard Law School

Jennifer ChienRicha GulatiKyle HollingsworthHaifeng HuangYen NguyenMatthew Peckosh

Graduate School of Arts and SciencesDamon ClarkKaren May-Shen Teoh

Graduate School of EducationEng Giat Yong

CONTENTS

4 Interview with Dwight Perkins: Asian EconomiesFive Years After the Financial CrisisHAQ Staff

A foremost scholar of Asian economic development shares with HAQ his views on thecurrent state of Asian economies. In a wide-ranging interview, Perkins offers well-con-sidered perspectives on key developments within individual economies as well as in theregion as a whole. The overall picture of Asia that emerges is one of great complexityand enormous variation among individual economies.

9 Corporate Governance Under Chinese Law:Problems and ProspectsLinan Yan

Since the opening of its two stock exchanges in the early 1990s, China has madeimpressive progress in improving its corporate governance regime, at least in terms ofthe volume of new legislation. However, in a trenchant analysis of the current governancepractices, Yan shows why serious problems in relationships among shareholders andbetween shareholders and managers of China’s publicly held corporations urgently callfor solutions, including the use of shareholder suits to alleviate corporate malpractices.

19 Interview with Anthony Neoh: Investing in ChinaHAQ Staff

The Chief Advisor to the China Securities Regulatory Commission talks to HAQ aboutthe securities laws being drafted in China to regulate its capital markets and promotegreater economic stability and investor confidence. While acknowledging China’schallenges in surmounting existing problems in the securities markets, Neoh offers anoptimistic picture of the ongoing reforms.

23 The Rise of China: Bane or Boon to Southeast Asia?John Wong

China’s rapid and sustained economic growth is casting a large shadow on its ASEANneighbors, many of whom have economies that compete with China in attracting foreigninvestment and in exporting manufactured products to the same third-country markets.However, Wong argues in this article that there is a complementary angle to China’sgrowth, which can operate as a new engine of economic development for the ASEANregion and thereby present a huge opportunity for ASEAN economies.


Volume VII, No. 2Spring 2003

HAR VARD ASIA QUARTERLY is a publica-tion affiliated with the Harvard Asia Center.HAQ was established in 1997 by members ofthe Harvard Asia Law Society in conjunctionwith students from other graduate and pro-fessional programs at Harvard University asan interdisciplinary journal of contemporaryAsian affairs.

LETTERSHAQ welcomes readers’ letters and com-ments. HAQ reserves the right to edit corre-spondence for length or format, and the rightto decline publication. Letters should be ad-dressed to the editor and submitted to the ad-dress below, or sent to: [email protected].

SUBMISSIONSHAQ invites the submission of articles andessays to be considered for publication. Sub-missions should address matters of contem-porary concern in Asia. Submissions shouldbe delivered in electronic form via email. Allsubmitted materials become the property ofHAQ. HAQ reserves the right to reject sub-missions and to edit materials for length, for-mat and content. To receive HAQ EditorialGuidelines, submissions schedules, or addi-tional information, please contact HAQ at theaddress below, or visit our website atwww.haqonline.org. Inquiries and elec-tronic submissions should be sent to:[email protected]

SUBSCRIPTIONSAnnual subscriptions to HAQ are available ata rate of $28.00 (individual subscribers) and$35.00 (institutional subscribers) for four is-sues delivered in the United States and $45.00for deliveries elsewhere. For more information,please contact HAQ or your academic peri-odical subscription service. Subscriptions areavailable at our website: www.haqonline.org.

Please address all correspondence to:

Harvard Asia Quarterlyc/o Harvard Asia Center1737 Cambridge StreetCambridge, MA 02138

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Credits:Cover Design: Damon Clark and Melody Chu.Photo credits: Damon Clark (cover); FelixWong, www.felixwong.com, (p.8, 13); Long Le(p.32, 34); The Financial Express (p.40); JohnChoy, www.photoshutter.com, (p.50).

No material appearing in this publication maybe reproduced without the permission of thepublisher. The opinions expressed in this pub-lication are those of the contributors and arenot necessarily shared by the editors or pub-lishers. All statements of fact and opinion rep-resent the work of the author, who remainssolely responsible for the content. All editorialrights reserved.

Copyright © 2003 by the President and Fel-lows of Harvard College. (ISSN 1522-4147).

31 Sustained Economic Development and PoliticalReform for VietnamLong Le

Is sustained rapid economic growth possible for Vietnam? If so, under what condi-tions? In an opinionated essay, Le argues that political liberalization is the key tounleashing the productive forces of Vietnam’s economy. Vietnam’s Communist Party,Le urges, must forego political expediency and pursue policies empowering its ownpeople.

39 Politics of Economic Liberalization in IndiaN. Chandra Mohan

Does politics drive economics or vice versa? In an insightful analysis, Mohanargues that politics does drive economics in India, especially as elections ap-proach. Mohan shows how two important economic policy initiatives of the currentcoalitional government, involving tax reform and privatization, have stalled becauseof the political need to satisfy powerful interest groups.

45 In Search of “Global Standards”: The Fallacy ofKorea’s Corporate PolicySung-Hee Jwa

Since the 1997 financial crisis, the term “global standards” has become the newbuzzword in Korea’s economic reform. In a provocative essay, Jwa discusses mis-conceptions surrounding this term and takes issue with the way the Korean govern-ment has uncritically embraced and sought to uniformly impose on Korean industriesand corporations “global standards” dictated by the international financial commu-nity.

53 Why Japan Cannot Reform: Social Contract and theWelfare SystemUlrike Schaede

What is holding Japan back from fixing its bad loan problem and successfully restruc-turing its industries? The answer, according to Schaede, is an insufficient welfaresystem and a failure on the part of the government to carry out its share of the country’sexisting social contract in market-conforming ways. For a solution, Schaede arguesone needs to focus on the troubles at the country’s many small firms, an importantpart of the economy thus far neglected in foreign analysis of Japan’s troubles.


Spring 2003

HAQ: Now, more than five years after the Asian financial crisis of 1997,how is Asia doing economically and what important post-crisis trends doyou notice? For one thing, despite the substantial progress made in clean-ing up bad debts in countries such as South Korea, several Asian coun-tries, including Indonesia, Thailand, the Philippines and China, still havefinancial systems plagued by massive amounts of non-performing loans.Is a second Asian financial crisis still a possibility?

Perkins : An Asian financial crisis similar to what occurred in 1997 is notvery likely if for no other reason than that countries learned the lesson ofwhat happens when there is massive unhedged borrowing abroad underthe assumption that the exchange rate will remain where it is. But otherkinds of financial crises could occur and one does not have to have acrisis for there to be a problem – Japan’s current financial situation beinga good illustration of a financial sector that is dragging down economicgrowth without creating a sharp crisis.

HAQ: Currently, the economies of the US, the EU and Japan have allslowed down. What effect will the deterioration of the major worldeconomies have on Asia?

Perkins : The main role of this slowdown is to slow down the growth inthe demand for Asian exports and that in turn is an important reason whyGDP growth rates have been slower than in the past.

HAQ: At the current rate of rapid growth, China is on its way to becomingthe dominant economic actor in Asia and, farther into the future, the largesteconomy in the world. Can the rest of the world live with this development?In what ways will the rest of the world adjust to such an outcome? Howis Japan going to position itself within an Asia dominated by China andwithin a multi-polar world economy?

Perkins : I think we should wait and see whether China can sustain itshigh growth rates for another decade or two before we start speaking ofChina becoming the largest economy in the world. If China continuesdevelopment based on participation in the international economic systemand becomes steadily more open to foreign imports, China’s economicgrowth should be beneficial to the economies of the rest of the world.The geopolitical implications of this development are another matter andaffect more than just Japan, but growth alone should not be a problem forthe rest of the world. It depends on what goes along with growth in termsof China’s long-term geopolitical goals.

HAQ: How would you assess the prospects for the rise of an East Asianeconomic bloc integrating China/Hong Kong/Taiwan, Japan, Korea andSoutheast Asia? Is it possible for East Asia to achieve an economic unionsimilar to the EU? What are some of the incentives and disincentives onthe part of the various East Asian nations for forming such a union? Issuch an economic union an unlikely prospect given the existence of the

INTERVIEW WITH DWIGHT PERKINS: ASIANECONOMIES FIVE YEARS AFTER THEFINANCIAL CRISIS

BY HAQ STAFF

Dwight H. Perkins is the Harold Hitchings BurbankProfessor of Political Economy and Director of theAsia Center at Harvard University. Previous posi-tions at Harvard include: chairman of the Depart-ment of Economics, 1977-1980, and Director of theHarvard Institute for International Development(HIID), 1980-1995. Perkins has authored or editedtwelve books and over one hundred articles oneconomic history and development, with specialreferences to the economies of China, South Ko-rea, Vietnam and other nations of East Asia. Hav-ing served as an advisor or consultant on eco-nomic policy and reform to the governments ofKorea, China, Malaysia, Vietnam, Indonesia, andPapua New Guinea, Perkins has also been a long-term consultant to the World Bank, the Ford Foun-dation, various private corporations, and agenciesof the US government.


ASEAN and the APEC?

Perkins : I would place a very low probability on an EastAsian economic bloc on the model of the EU. The countriesin Asia are more competitive with each other thancomplementary and the result is that trade within the regionis not anywhere near as large a share of their total trade as isthe case with the members of NAFTA and the EU. The low-income countries in particular are competing with each otherfor the export markets in textiles, shoes, electronics and othersimilar labor-intensive products. There is more potential fortrade development between thecountries at the high-income end suchas Japan and South Korea and thoseat the low-income end, and one cansee this in the rapid development ofJapan-China and South Korea-Chinatrade, for example. The competitivenature of trade between many of thecountries in the region does not implythat the region will not sign free tradeagreements and the like, but that is along way from having a common government and a commoninternal and external economic policy.

HAQ: What economic benefits do you think China’s WTOmembership has brought or will bring to China, the US andthe international economy? What are the negativeconsequences, if any?

Perkins: The main benefit that the WTO has brought toChina is that it has helped bring competitive pressures onthe inefficient state sector in China, which should contributeto either the reform of that sector or its abolition. Membershipalso helps stabilize China’s access to world markets andensures that many trade disputes will be handled by apoliticaltechnicians rather than politicians, and that is good for bothChina and the US.

HAQ: China seems to be vastly more adept than otherdeveloping nations, India, for example, at attracting foreigninvestment. In what specific ways has China made aconcerted effort to create a favorable environment forinvestment? Also, what lessons can other developing nationslearn from China?

Perkins: Most small nations won’t be able to learn that muchfrom China because they do not have China’s large domesticmarket to attract investment from abroad. India and otherscan see from China, however, that a concerted effort to createa favorable environment for investment will pay off in theincrease in the flow of that investment. China began byannouncing that it was encouraging foreign direct investment,and then backed that up with the passage of a variety of lawsdesigned to provide a favorable tax and regulatoryenvironment for investment. More recently, the agreementsconnected with China’s joining of the WTO provide furthersupport for expanded foreign investment, particularly in thefinancial sector. India and a few others might also learn fromhow China has proven to be particularly attractive for

investment from the Overseas Chinese diaspora.

HAQ: Will direct trade between China and Taiwan bepossible? If so, how will this affect the regional economy?

Perkins: I believe direct trade will become a necessity forTaiwan if it wants to become a major economic center in theregion. Taiwan is well-placed to play a major role in China’seconomy and it is already doing so, but the current restrictionson direct contact seriously hobble this influence.

HAQ: If and when China’s economicgrowth slows down or even turns intoa prolonged recession, will this lead topolitical destabilization or even asudden regime change? If so, what willbe the consequences and how can therest of the world cope with such anoutcome?

Perkins: A major and prolongedslowdown in China’s economy could

lead to serious internal tensions and could well destabilizethe government in power at the time. It is hard to come upwith any scenario where that would be a good thing for therest of the world. The rest of the world should focus onhelping to prevent conditions where this might happen.

HAQ: In response to concerns over economic threats posedby the up-and-coming economies of China and India, at leasta few of the ASEAN nations have made attempts to promotea forum for intra-regional economic cooperation, such asthe AFTA and the ASEAN + 3 framework. What are yourviews on the scope of economic integration that can beachieved by the region? What is the prospect for the ASEANeventually developing into a regional economic bloc alongthe lines of the EU?

Perkins: I have basically answered this already in generalterms. This particular free trade area is likely to have a modestpositive impact on trade between the member countries, butthese are precisely the countries that are more competitivethan complementary except in the field of natural resources,where trade restrictions tend to be minimal anyway.

HAQ: Following the financial crisis of 1997, the economicperformance of the ASEAN countries has been rather unevenacross the board and across time. Are these growth disparitiesgoing to become a permanent fixture in the region and willthey lead to the emergence of income stratification betweenthe countries?

Perkins: The main problem is Indonesia and there is littleprospect for Indonesia’s return to high growth until they areable to complete the transition to a more stable politicalsystem. Where and how that will happen will also have aconsiderable influence on the region. The Philippines’economy will probably continue to be plagued by thecountry’s populist politics, but several other countries in theregion should return to fairly high growth and to some degree

A major and prolongedslowdown in China’s economycould lead to serious internal

tensions and could welldestabilize the government in

power at the time.


Spring 2003

already have.

HAQ: Is the ASEAN region well-placed and well-preparedto handle the challenges that are and will be brought aboutby a fast-developing Chinese economy? How real is this“China threat”? Is it really a zero sum economic gamebetween the two parties as painted by some observers or arethere opportunities to be mined in the course of China’seconomic growth that will make up for the losses to theASEAN in terms of manufacturing competition and FDI?Furthermore, can you elaborate on specific ways in whichthe Southeast Asian nations can get their economic policiesright?

Perkins: Economic growth is rarelya zero sum game and thus China’sgrowth should be a benefit to theregion. There is a problem forcountries such as Malaysia that relyheavily on foreign direct investmentand have carried out policies that havehindered their own domesticinvestors. These countries could loseFDI to China and not have the domestic investors to stepinto the breach. But, if Southeast Asian countries get theireconomic policies right, there is no reason why they cannotcompete with China. Any attempt to spell out precisely whatindividual Southeast Asian nations should do would take upmany pages of this interview. But one example in the case ofMalaysia is the need to foster the development of domesticfirms that can export manufactures so that the country is notso heavily dependent on foreign firms for the export ofmanufactures. That in turn requires Malaysia to rethink someof the provisions of its policies designed to promote thedevelopment of Bumiputra businesses.

HAQ: ASEAN has long worried about Chinese intentionsin the South China Sea. How does this issue affect economicrelations between China and the ASEAN? If there are seriousproblems resulting from this issue, what can China do toresolve them?

Perkins: As long as the politicians think there is a lot of oilunder the sea in this region and they believe that oil is criti-cal to their long-term economic success, there will be ten-sion in this region. At some point, one hopes that all of thesecountries will realize that the advantages of directly control-ling this oil are small compared to the disadvantages of hav-ing hostile neighbors, and at that point some compromiseover the development of the South China Sea should be pos-sible.

HAQ: Will the economic success of Vietnam lead to changesin Indochina, a region that is still characterized byauthoritarian regimes such as Laos and Burma?

Perkins: It hasn’t led to major political changes in Vietnamas of yet and is not likely to do so in the near term, so I doubtthat there will be much influence on political change in Laos,and this is even more true of Burma which has little relation-

ship to Vietnam. Over time, economic development in Viet-nam will no doubt lead to an increasingly open political sys-tem, and that in turn could lead to the creation of a legalpolitical opposition and more democratic elections. But itwill take more than just a rising standard of living to createthese changes, and progress of this sort is likely to be mea-sured more in decades than in years.

HAQ: Turning to Japan, how can Japan get out of the cur-rent malaise it finds itself in? Is reform impossible? In par-ticular, what can provide a solution to the hydra-headed prob-lems of enormous bad debts, an aging population and thelack of an adequate social welfare system to provide cush-ion against unemployment?

Perkins: This is too complicated a setof issues to deal with here, but theessence of what is required is no se-cret. Japan needs to reform its finan-cial system and its service sector moregenerally, and it needs to find a wayto stimulate a return to economicgrowth that does not involve a con-

tinuing rise in the already very high debt to GDP ratio, whichis likely to soon become unsustainable. I don’t know howthey are going to deal with their rapidly aging population,but they clearly won’t be able to improve their support muchif they don’t get back to sustained economic growth.

HAQ: Due to heightened tensions involving North Korea’snuclear program, Moody’s Investors Service recently slashedits ratings outlook for South Korea by two notches from“positive” to “negative.” This was the first time a globalratings agency has lowered South Korea’s outlook since thecountry bounced back from the 1997 economic crisis, andthis had an immediate effect on financial markets in Seoul.How serious a threat does the North Korean problem poseto the economy of South Korea and economic stability inAsia as a whole?

Perkins: If the nuclear weapon development efforts of NorthKorea lead to military action to eliminate that development,the impact on the South Korean economy would beenormous, and the probability of there being military actionwould be well above zero. Any rating agency is bound totake that possibility into account.

HAQ: In general, how would you evaluate the progress SouthKorea has made under President Kim Dae Jung in reformingits economy after the Asian financial crisis of 1997? Has theeconomy been strengthened enough so that it is now readyfor reunification with North Korea? As for North Korea,despite or because of the economic bankruptcy of thisStalinist regime, is it ready for reunification with the far moreprosperous South Korea? What are some of the majorremaining problems for the South Korean economy and howcan these be addressed by the new Roh administration?

Perkins: This is a question that would require an essay toanswer. To deal with only a part of the question, the North

There will be tension in theregion as long as South East

Asian politicians think there is alot of oil under the South China

Sea.


Korean economy is not remotely able to be integrated withthe South Korean economy, except under conditions thatwould see most North Korean industries shut down and thelabor force slowly absorbed over a number of years by SouthKorean companies. It is unlikely that there are anyinternationally competitive companies in the North, althoughpower plants and the like would continue to function.Reunification would pose enormous economic challengesfor the South with the choice being millions of migrantsmoving south in search of jobs or huge subsidies movingnorth to keep the North afloat.

Reforms in South Korea since the 1997 crisis have beensubstantial. The corporate debt to equity ratio is way down,the banking system is much healthier, and the governmenthas demonstrated that there is no suchthing as being too big to fail. I believewhat the government needs to do nowis to back away from getting involvedin specific corporate restructuringissues. Governments are not very wellqualified to do that, and it is not clearto me that the Korean economy willbenefit from government-ledrestructuring. The government insteadshould be concentrating on strengthening the institutions ofa market system – particularly, the legal system. Korea hasthe foundations of a good economic system for commercialneeds, but it needs to be expanded and to become more expertin a variety of commercial areas so that most corporaterestructuring issues can be handled by the companiesthemselves with the courts acting as neutral enforcers of therules.

HAQ: What are the most significant consequences of foreign-trained Asian economists returning to and working in theircountries of origin, whether as policymakers, academics, orbusiness leaders? Do you see the effects as mostly positive,or can you identify any potential downsides? “Foreign-trained,” as you know, can mean a variety of things, rangingfrom receiving one’s undergraduate and graduate educationabroad to participating in short-term programs. In addition,what are the consequences of an Asian “brain drain,” namely,that of Western-trained Asian economists and otherprofessionals remaining in the West rather than returning totheir home countries?

Perkins: I believe that the Asian economists who havereturned home and have gotten involved in policy issues havehad an enormous, mostly positive influence on the economicdevelopment of their countries and on the quality ofeconomics education in those countries. This is true ofeveryone from the Berkeley “mafia” in Indonesia to theeconomists who went back to South Korea in the 1960s and1970s and the Chinese economists who are now beginningto return home to China. I used to worry more about thebrain drain from places like China, but the opportunities inAsia are often so much more challenging than those in theUnited States or Europe that I believe most countries in theregion will see an increasing return flow of trainedeconomists. This did not happen in China in the 1980s and

early 1990s but is happening now. In economies such asSouth Korea or Taiwan, where 90% of the students who wentabroad in the 1950s and 1960s did not return, now 90% doreturn and only a handful remain in the US.

HAQ: What are your views on affirmative action policiesfor ethnic and religious minorities on the part of Asiangovernments? In the past fifty years of de-colonization andnation-building, what effects, politically and economically,have these polices had? Overall, have they been successfulin achieving their intended goals?

Perkins: I am not sure what you are referring to when youspeak of affirmative action policies directed at ethnic and

religious minorities. In Malaysia,there is a policy of trying to raise therelative income and employment levelof the majority, the Malays, and thatpolicy has had some positive impacton Malay standards of living andlevels of education, but it has also hadsome costs to the society as a whole,not the least of which is the lack ofinternationally competitive domestic

firms that I mentioned earlier. On the whole, much of Asiaranging from Japan through China to India does not have avery positive record when it comes to protecting the rightsand enhancing the economic opportunities of the minoritiesin their midst.

HAQ: What have been the major effects of intra-Asianmigration in the recent years? Please address both short-termlaborers – skilled and unskilled – and individuals who go toanother country for their education and remain there.

Perkins: My impression is that the main intra-Asianmigration has been from the Philippines to various other partsof Asia, and this reflects the fact that the Philippines has alarge surplus of well-educated people that cannot findadequate jobs at home and so they go to Hong Kong andelsewhere. There is also some illegal migration even to Japan,but most Asian countries do not make it easy for people tomigrate across borders. Indonesians do go to Malaysia andSingapore to fill low-skill jobs. I am not well enoughinformed about this latter migration to have a judgment onwhether its overall impact is positive or negative, butgenerally I tend to believe that migrations of this sort arepositive even if some of the people in the receiving countrydon’t like it. I feel the same way about Mexican migration tothe US.

HAQ: Some predict that Shanghai will replace Hong Kongas the de facto financial hub of Greater China. Given theChinese government’s aspirations for the city’s future, whatdeeper-level implications do you see for the development ofShanghai vis-à-vis Hong Kong? If Shanghai is to trulybecome such a financial powerhouse, what kinds of changeswill be necessary?

Perkins: Shanghai may someday surpass but not replace

Returning Asian economists havegotten involved in policy issues

and have had an enormous,mostly positive, influence on

their countries’ economicdevelopment.


Spring 2003

Hong Kong as a financial center; it has a long way to go.The first step for Shanghai is to create a number of modernefficient banks, but this is a national Chinese problem, not alocal Shanghai issue. Banks with 40% of their assets non-performing aren’t going to be very competitive with HongKong banks. The Hong Kong stock market is far from perfect,but it is far ahead of Shanghai’s in being able to control insidermanipulation of stock prices and other such predatorybehavior. Shanghai is learning fast but there is still a big gapbetween where Shanghai is today and where it will need toget to be truly competitive in these sectors vis-à-vis HongKong. And when Shanghaidoes catch up, that does notmean it will replace HongKong. As I have said before,economic development isnot a zero sum game.

HAQ: Touching further onShanghai’s future as thefinancial hub of GreaterChina, how would this riseof Shanghai affect the statusof Singapore and Tokyo asAsian financial centers?

Perkins: Tokyo is mainly afinancial hub for Japan andmuch needs to be done tomake it a more efficient andcompetitive financial hub inorder to serve that goal.Singapore is mainly oriented toward the markets of SoutheastAsia. I don’t see Shanghai as having much influence on theroles of these financial centers anytime in the near future.

HAQ: What are the prospects for the renminbi, the Chinesenational currency, in the long run? Do you see it becoming afloating currency, despite the assertion by the Chinesegovernment that it will remain pegged to the US dollar forthe foreseeable future? If yes, will the currency’s valuechange appreciably?

Perkins: I feel the Chinese government needs to get awayfrom what amounts to a peg of the currency to the US dollar,not because there is any problem from the Chinese point ofview with the current level of the renminbi. It is just thattimes change and currencies become overvalued for onereason or another and devaluation becomes necessary.Devaluation in the midst of a crisis tends to exacerbate thecrisis, which is why China would be better off getting peopleused to regular, if small, changes in the value of the renminbi.If I had to guess, I would say that the Chinese renminbi iscurrently undervalued, although that might not be true ifChinese capital markets were liberalized.

An undervalued currency has some advantages for Chinabecause it helps promote Chinese exports and thus helpsmaintain China’s high growth rate, as was the case in SouthKorea in the 1960s and 1970s, but, over the longer run, Chinacannot continue to push exports in this way. If the renminbi

on the Chinese capital markets was made fully convertible,and if imports were fully liberalized, then there might turnout to be a larger capital outflow and a higher growth rate ofimports. If that happened, the current value of the renminbimight turn out to be just right for maintaining a healthybalance of payments. But, it will take time to liberalize capitalmarkets and imports, and in the meantime I think one shouldcontinue to see the renminbi as being somewhat undervalued.

HAQ: With the Euro now challenging the US dollar as aninternational currency, what are the prospects for the

emergence of a commonEast Asian currency? Is thisan impossibility given thewide cultural, economicand political disparitiesamong the various EastAsian countries?

Perkins: I believe there islittle prospect for a commonAsian currency over thenext decade or two. Acommon currency requirescoordinated monetary andfiscal policies, andcoordinated policies requireshared economic goals andstandards and a willingnessto live by them. Thedevelopment levels andinterests of the countries of

Asia are much too diverse for this to be possible in the nearfuture. Vietnam and Japan have almost nothing in commonin terms of economic conditions or goals, to take only one ofthe more extreme binary comparisons.

Shanghai: future financial powerhouse.


While it is still subject to debate whether the debacles of Enronand others reveal fundamental weaknesses in the US corpo-rate governance system, 1 many in China blame corporate gov-

ernance failures for the rampant corporate wrongdoings plaguing China’sfledgling stock market.2 Within a decade of its launch, China’s stock markethas already overtaken Hong Kong’s and become the second largest inAsia trailing only Japan’s. In the meantime, however, disclosure irregu-larities and dubious self-dealings are seen by some companies as normalpractices.3 As victimized stockholders grumble about their losses, com-mentators warn of the danger of falling public confidence in the marketand call for better shareholder protection.4 China’s regulators seem tohave taken notice. Indeed, reform-minded government officials make itknown that they believe that more effective governance institutions mustbe in place before a deep, liquid equity market can be expected.5

The extent of China’s legal reform concerning corporate governancesince the opening of its two stock exchanges in the early 1990s has beenimpressive by any standard. For instance, China has promulgated a broadarray of laws, including the Company Law (1993; amended in 1999), theCertified Accountant Law (1993), the Audit Law (1994), the Commer-cial Bank Law (1995), the Securities Law (1998) and the AccountingLaw (1999), to name a few. Moreover, the China Securities RegulatoryCommission (CSRC) was installed in 1992 with the primary responsibil-ity to supervise and regulate securities markets. The CSRC has issuedofficial notices and orders directly targeting such governance issues asshareholder meeting (1998, 1999, 2000) and independent directors (2001).Most notably, the first ever Code of Corporate Governance for ListedCompanies (CSRC Code) was issued in January 2002.

Impressive legislation notwithstanding, the volume of laws is notnecessarily a proxy for quality or impact thereof,6 nor does it mean China’scorporate law is complete. Instead, more arduous tasks lie ahead forChina’s reformers. This article discusses contemporary governance prac-tices in China, with the focus on the effect of law in facilitating the “es-tablishment and improvement of the modern enterprise system of listedcompanies,” as claimed in the CSRC Code. It first identifies and exam-ines major problems with the legal and institutional mechanisms meantto deal with relationships among shareholders, and between shareholdersand managers (directors and officers), of China’s publicly held corpora-tions. The article then seeks to evaluate and prioritize plausible solutionsto those problems and draws particular attention to the use of shareholdersuits in alleviating corporate malpractice in the current Chinese context.

ISSUES AND PROBLEMS

Publicly held corporations did not exist in China until 1990 whenthe country’s only two stock exchanges, the Shanghai Stock Exchangeand the Shenzhen Stock Exchange, came into being. Vexed with the lossesof China’s stated-owned-enterprises (SOEs) yet fearing the consequencesof total privatization of the SOEs, the government wanted the securitiesmarkets to serve the policy objectives of both channeling idle householdsavings to capital-thirsty SOEs and diversifying the SOEs’ state owner-

CORPORATE GOVERNANCE UNDERCHINESE LAW: PROBLEMS ANDPROSPECTSBY LINAN YAN

Linan Yan is an associate at LeBoeuf, Lamb,Greene and MacRae L.L.P. He received his LL.M.from Harvard Law School, M.B.A from Universityof Michigan, and both LL.B. and B.A. from BeijingUniversity. He would like to thank Petja Toskanfor his valuable comments and his firm for itslogistic support.


Spring 2003

ship – to a certain degree. The government hoped that diver-sification of SOE ownership would result in higher levels ofSOE efficiency. The laws promulgated in the early 1990s,exemplified by the Company Law, were enacted primarilyto facilitate this process, although later laws show more di-versified views about the regulated subjects; the SecuritiesLaw, for example, attempts to establish elaborate share trans-fer procedures and impose detailed disclosure rules appli-cable to more market-oriented business organizations.

The fact that this reform process started as anexperiment7 conducted from the top is something that needsto be borne in mind when looking at China’s corporate scene.The experimental nature presagespolicy changes and results in a senseof uncertainty among stock marketparticipants, thus contributing directlyto volatility and speculation in the mar-ket. To the extent that reform is beingcarried out in a top-down manner, in-volvement by private sector and citi-zenry in formulating sensible governance policies has beenvery limited. This certainly does not help rectify the some-what reductionist attitude toward reform; in the case of cor-porate governance, such an attitude is exhibited in the word-ing of the laws which suggests that lawmakers clearly hadSOEs in mind during the drafting process. Yet by definitionthe corporation is very different from the SOE.

Moreover, the majority of today’s 1200-odd listed com-panies8 are directly or indirectly controlled by the state. Thisgives rise to several ramifications. First, investors – smallindividual investors in particular – make their decisions tobuy or sell partly based on the perception that the govern-ment will probably never let a major public company fail,just as it has almost always bailed out troubled SOEs. Sec-ond, corporate managers are different from their Westerncounterparts in that they neither evolve from entrepreneurswho started their own businesses nor are employed for theirexpertise in business management. In fact, many of them areformer SOE cadres and are appointed by the government orgovernment-controlled entities. To them, increasing fixedcapital is a better method of improving productivity thanactual innovation. They still view themselves as and act likequasi-governmental officials, caring more about their offi-cial career advancement than about their companies’ profit-ability prospects, because they know their performance willnot be assessed based on maximization of firm value. In-stead, political correctness and willingness to shoulder soci-etal responsibilities are probably more important consider-ations for assessment by their political bosses. Many man-agers lack both the capacity and the incentive to compete inthe product market.

Such indifference to long-term firm value-building isalso sometimes felt by managers of non-state-controlledfirms, because, especially in the early years of the stockmarket, it just seems a lot easier to make a fortune by “play-ing the market.” From the outset, the stock market has beena “seller’s market,” with almost all public offerings beingoversubscribed. This is partly due to the limited investmentoptions available to Chinese investors.9 The perception thatthere always seems to be buyers for public offerings tempts

businesses to do everything possible to get listed on a stockexchange so as to harvest some “easy” money, creating theincentive for managers to inflate or otherwise fabricate ac-counts and other information to go public. In addition, as amatter of culture, managerial myopia also afflicts sharehold-ers who tend to believe that the “greater fool” theory10 makesmore sense than the “buy-and-hold” strategy, as would bethe case in probably any volatile stock market. Yet a buy-and-hold strategy is a prerequisite for monitoring,11 becausean investor who does not intend to hold her shares for atleast some time cannot be reliably expected to care seriouslyabout the corporation’s operation. Thus since the inception

of public companies in China, neithermanagers nor shareholders have dis-played particularly strong zeal for thelong-term performance of their corpo-rations.12

Finally, it helps to take a brief lookat the public offering approval process.For the most part, the decision to allow

a business to issue public shares is in the hands of the gov-ernment, not the stock exchanges. Under the Securities Law,the State Council determines whether to set up or give up astock exchange, and the CSRC has the power to appoint andremove the head of the two stock exchanges. The CSRCalso has the final say in laying down the charters for bothstock exchanges. The lack of autonomy on the part of thetwo stock exchanges to select listed companies and formu-late trading policies suggests a minimal ability to regulatepublic companies traded on their floors. In addition, the seem-ingly high barriers to market entry mandated by the govern-ment are no assurance of the quality of listed firms. For thefirst nine years of the stock market’s history, companiesapplying for IPOs were selected under a quota system thatdictated how many companies in what industries or fromwhich provinces were to be listed on one of the two ex-changes, employing screening criteria not strictly based onfinancial performance. Starting in 1999, the CSRC created aspecial examination committee in charge of this screeningprocess. Composed of securities professionals, officials, sci-entists, professors, and “celebrities” (zhiming renshi), the ex-amination committee has encountered enormous difficultiesin reviewing often voluminous application materials; manyof the members lack the necessary background and trainingand most do not have enough time for this demanding part-time job. To make matters worse, not all of so-called“reputational intermediaries” – accounting firms, investmentbanking firms and law firms – appear to care about theirprofessional reputations: instead of credibly vouching forthe quality of particular securities, some intermediary firmshave been caught aiding and abetting managers in fabricat-ing financial statements.13 In any event, poor quality controlof listed companies has not only created fertile ground fordisclosure irregularities, but also directly contributed to thedistortion of governance standards for China’s public com-panies.

OWNERSHIP STRUCTURE

Highly concentrated share ownership is common among

Many managers lack both thecapacity and the incentive to

compete in the product market.


China’s public companies. The largest shareholding stake inthe listed companies averages close to 50% while the sec-ond largest shareholder typically owns less than 10%.14 Theprivate benefits of control, i.e., the rights a controlling share-holder enjoys in excess of her cash flow rights through par-ticipation in corporate management, play a critical role incausing share concentration in all listed firms. For formerSOEs, the government’s desire to cling to state property rightsseems to be another reason that, after going public, stateshares in virtually all those firms maintain an absolute con-trolling position. Meanwhile, pertinent laws do not discour-age close ownership; for example, there are no anti-blockholding rules in China. Nor doesthe law impose any serious constraintson the extraction of private benefits ofcontrol. Neither the Company Law northe Securities Law says a single wordabout minority shares, except one pro-vision of the latter providing some sortof takeout right allowing shareholdersto sell their shares to the new control-ling shareholders when 90% or greaterstake in the firm is acquired. The CSRCCode does mention the phrase “minority shareholder” onseveral occasions, but does very little more than make cer-tain policy statements claiming “all shareholders are equal”and “controlling shareholders owe a duty of good faith toother shareholders.”15

The existence of controlling shareholders does not nec-essarily signal weak corporate governance; in more devel-oped equity markets, controlling shareholders, because oftheir larger stakes, tend to hold stronger incentives thansmaller shareholders to oversee managers in order to maxi-mize profits. Such supervision can confer a public good onall corporate stakeholders by deterring wasteful or oppor-tunist behavior by corporate officers and directors. How-ever, several features – some of them unique to China – ofshare concentration in the stock market render it unrealisticto expect controlling shareholders to play the role of moni-tors. First, in about four-fifths of the cases the controllingshares are owned by the state and corresponding control isexercised either directly by government appointees (called“state shares”) or by representatives of government controlledentities (called “legal person shares”). In either case, gov-ernment representatives are controlled by political interestsand have at best an indirect concern about corporate earn-ings. Anecdotal evidence suggests they are either wantonlyslipshod in voting the state shares/legal person shares or,worse, collude with opportunist managers in self-dealing(contracting by an insider directly with the corporation) oroutright stripping of corporate assets. Hence to the eyes ofat least some policymakers, the government now faces thesame set of problems as it did in the past when dealing withwayward SOE cadres, except perhaps this time around thevictims of mismanaged firms are not just state assets butalso the interests of small shareholders.

Second, state shares and legal person shares, account-ing for somewhere between 60% and 70% of the total mar-ket capitalization, are still forbidden from being traded inthe market by an early 1990 order from the State System

Reform Commission. With only about one third of the totaloutstanding shares in circulation, share prices are hardlyaccurate reflections of performance. Corporate insiders –officers, directors and controlling shareholders – thereforefeel safe to ignore reactions from the market as well as con-cerns of small shareholders. Third, as discussed in more de-tail later, the existing legal regime is not sophisticated enoughto curb insider excesses on either of the following twogrounds: (1) giving shareholders explicit rights ex ante toprevent controller expropriation and (2) providing remedialmeasures ex post if expropriation occurs.

On the other hand, minority shares, accounting for thevast majority of tradable shares, arespread out and not actively voted. In-stitutional investors, sometimesviewed as active corporate watchdogsin other jurisdictions (such as in the USafter the issuance of the SEC “safeharbor” rule in 1992),16 currently ownan average of less than 1% stake inChina’s public companies. One posi-tive development may lie in the possi-bility of allowing foreign institutional

investors to enter the market; such investors might be ableto play an active role in corporate governance, as the gov-ernment hoped when issuing regulations in late 2002 allow-ing foreign investors to trade A-shares.17 But the success ofsuch a move will depend on how much confidence foreigninvestors place in the quality of China’s public companies(given the lack of transparency of the market) and in theefficacy of available governance mechanisms dealing withcorporate self-dealing. In the meantime, the fact remains thatdispersed small individual shareholders, owing to poorlyenforced disclosure regulations, tend to be ill-informed andhave shown little interest in exercising their voting rights.Weak in power, institutional investors are not doing any bet-ter. As a result, non-controlling shareholders fail to rigor-ously watch corporate insiders who have the power and theincentive to engage in unlawful expropriations. The conven-tional model of corporation in which managers are expectedto maximize long-term firm value and owe fiduciary dutiesto shareholders is far from a reality in China. Instead, mostof China’s public firms are run by controlling shareholdersthrough non-professional managers who face few legal risksand are accountable to virtually no one.

BOARD OF DIRECTORS

The board of directors is designed to be an essentialpart of the governance process under Chinese law. The Com-pany Law, for instance, sets forth fairly elaborate rules con-cerning the size, composition, and decision processes of theboard. As a legal matter the directors, acting collectively asrepresentatives of shareholders, have extremely broad pow-ers and responsibilities. These powers include the manage-ment of the corporation, including the convening of share-holder meetings, the formulation of the internal control struc-ture, the appointment and removal of the chief executiveofficer, and, more generally, the making of major businessdecisions concerning investment, operation, dividends,

Most of China’s public firmsare run by controllingshareholders through

managers who face few legalrisks and are accountable to

virtually no one.


Spring 2003

merger and dissolution.18 The CSRC Code complements theCompany Law by specifying the board’s powers to includethe delegation of decision-making authority to various sub-committees.

In most of the public corporations, however, the actualfunctions carried out by a board of directors, in particularthose safeguarding shareholder interests, are much moremodest than the law suggests. It is extremely rare to observedirectors evaluating performance of the firms’ executive of-ficers, let alone hiring or firing them. On the contrary, it isprobably closer to the truth to say that the incumbent man-agement selects directors, not vice versa. The reason is quitestraightforward: most firms don’t havedirectors until the firm’s“corporatization” (gongsihua, refer-ring to the transformation of SOEs intojoint-stock corporations), at whichpoint they are legally required to havea board of directors. After the firm’scorporatization or IPO, any changesto the board continue to be made bycontrolling shareholders, who typi-cally select 70% of the directors. Directors do meet once ina while for a few hours each time (the Company Law re-quires at least two meetings annually), but the managementsets the agenda. During board meetings, directors usuallylisten to what executive officers have to say and consent tothe officers’ demands. The Company Law stipulates a quo-rum for all board decisions to be a majority of the entireboard (not a majority of those present at the meeting). How-ever, with up to 80% of the directors either picked by themanagement or themselves executive officers, there is verylittle that outside directors can do, even if they (in the veryrare instance) disagree. Directors do not have the right tobring actions on behalf of the corporation under the law. Asa result, the boardroom lacks contention and dissent; trustand contructive dialogue are missing as well.

Furthermore, compared with jurisdictions where direc-tors carry the risks of being fired “without cause” or suedfor duty dereliction, boardrooms of China’s listed firms arefairly safe places19 because directors cannot be legally let gobefore the end of their tenures without cause. The only tan-gible risk under the Company Law appears to be the liabilityfor indemnification to the corporation in the event of “graveloss” to the corporation caused by a director in violation oflaws, regulations, or the firm’s own charter or “article oforganization.” It is unlikely that the level of such risk sig-nificantly increased after the CSRC removed the word“grave” when issuing the CSRC Code in 2002. For one thing,it has never been clear – through direct reading of the law orby virtue of explanations of the Supreme People’s Court(SPC, China’s court of last resort) – how grave is grave.Moreover, when conflicts arise, the CSRC Code (issued bya Cabinet department) lacks the legal force to prevail overthe Company Law (enacted by the National People’s Con-gress, China’s supreme legislative body). Nonetheless, byfar the more problematic issue is that directors of China’slisted firms have virtually no need to fear being sued by share-holders, because no law has yet given shareholders such aright. The only feasible avenue available under the law

whereby shareholders can attack a director is to try to firehim “for cause” at a shareholder meeting. However the lawis quite murky about what constitutes “cause.” In practice,some companies have managed to define the term in theircharters to include only situations where there is a court judg-ment declaring that the director is at fault.20

When it comes to monitoring management dominatedby a controlling share, the conventional wisdom is the ap-pointment of independent directors, outsiders who have nopersonal financial stake or operational responsibilities in thecorporation. The Company Law’s silence on the subject ofindependent directors should probably not be viewed as a

grave regulatory shortcoming. TheCSRC has gone out of its way to pro-mote the notion of independent direc-tors and issued the Guidelines for In-troducing Independent Directors to theBoard of Directors of Listed Compa-nies in 2002. The Guidelines sets forthin great detail the powers, necessaryqualifications, independence require-ments, and rules for nomination and

replacement of independent directors. Most notably, publiccompanies are required to give independent directors greaterpowers and responsibilities than other directors. For example,major transactions between a corporation and its affiliatesmust first be approved by independent directors. The CSRCplans to ask public firms to have independent directors makeup at least one-third of board members by mid-2003; theCSRC also wishes to form a “pool of independent directorcandidates” for companies to choose from so as to alleviatethe present short supply of candidates.21 Presumably, inde-pendent directors are independent of both the managementand controlling shareholders, resulting in uncompromisedcheck-and-balance capacities. However, anecdotal evidencefrom corporations indicates that independent directors’ im-pact has been extremely modest, for they rarely voice opin-ions different from the rest of the board.

The disappointing impact of independent directors isnot surprising if one considers the context. First, as withcorporate directors in general, the majority of independentdirectors are characteristically incapable of engaging seri-ously in examining corporate financial activities, despite theCSRC’s great effort to press for the recruiting of accountingexperts as independent directors. While this problem mightbe treated by providing the necessary training, another issueraises more fundamental questions about the independentdirector institution: that is, the confusion as to whose inter-est is supposed to be served by such directors. In theory,independent directors should be independent of managementbut must also be dependent on and accountable to share-holders.22 The real picture, however, is quite different. Inde-pendent directors have no channels to communicate directlywith investors: neither the above-mentioned Guidelines norany other laws provide any. Furthermore it is difficult tomonitor independent directors, given the lack of a competi-tive market for quality candidates. In the meantime, inde-pendent directors have to rely on insider-controlled man-agement to make any meaningful work possible. No matterwhat the law says about their powers and responsibilities,

With up to 80% of directorseither picked by the

management or themselvesexecutive officers, there is verylittle that outside directors can

do.


independent directors understandably feel uncomfortable be-ing a nuisance to the managers who made them the “job of-fer” and put them on the payroll. In addition, their pay (or“allowance” as termed in the Guidelines), usually a cashpayment,23 has to be proposed by the board and approved bythe shareholder meeting (both controlled by the controllingshareholder).

Many independent directors are chosen from academiaand most are not from cor-porate executive circles (asis the case in the US); there-fore they do not share cor-porate managers’ “infec-tious greed”24 or their ideo-logical loathing towardshareholder monitoring.However, this advantagedoes not offset the greaterdisadvantage that, as share-holder watchdogs, indepen-dent directors do not appearcapable of barking, owinglargely to their dubious in-dependence and missing in-centives.

SUPERVISORY BOARD

The notion of the supervisory board is nothing original;a separate supervisory board composed of outsiders is man-datory under German corporate law, for example.25 However,the supervisory board mechanism mandated by China’s Com-pany Law is unique in that most supervisors have little ideaof the board’s purpose. The idea stemmed from the practice,in the early stages of China’s reform, of delegating govern-ment officials to supervise activities of SOE cadres. Althoughthe existing law intends that the supervisory board be a checkon both the management and the board of directors, and re-quires that supervisory board members consist of both share-holder representatives and employee representatives, mem-bers are often found either merely duplicating the functionsof the board of directors, or left helpless when dealing withuncooperative officers or directors. Either way, the institu-tion of the supervisory board appears self-defeating. The rea-son is a familiar one: the Company Law instructs the super-visory board to “supervise directors and officers” but saysnothing about what to do when facing resistance. Like di-rectors, members of the supervisory board do not have aright to sue on behalf of the corporation. But unlike direc-tors, they lack power to get involved in the appointment andremoval of managers. In addition, there is the question abouthow to motivate supervisory board members; for example,they are unlikely to get paid unless mandated by law, but thelaw is silent here. If they do get paid, then confusion mightarise about to whom they should pledge their loyalty. Assuch, a supervisory board contributes few improvements tocorporate governance.

SHAREHOLDER ACTION

China’s shareholders’ preference for short-term liqui-dation over a buy-and-hold strategy also reflects the realitythat simply selling their shares is the easiest among all theiroptions to assert their control over corporate managers. Smallshareholders do not really have many options to begin with.There is no such thing as appraisal rights (a remedy allow-ing dissenting minority shareholders to sell their stock to thecorporation at a price equivalent to its value immediately

prior to the extraordinarycorporate action) under thelaw; nor are there preemp-tive rights to new issuesavailable to protect share-holders from dilution bycontrolling shareholderswho could otherwise issuenew shares to themselvesor friends. Exercising vot-ing rights is too much of ahassle with too little gain,despite the extensive regu-latory efforts encouragingshareholder voting. Lastly,the right to sue, except in aminor way, remains verylimited.

To be sure, the Com-pany Law and the Securi-

ties Law do pay much attention to general shareholder rightsissues such as shareholder meeting procedures, but they lackclarity and precision. Recognizing such infirmities, the CSRCdrafted and issued the Guidelines for Shareholders’ Meet-ings of Listed Companies in 2000, spelling out more de-tailed requirements concerning, among others, shareholdermeeting notice and voting methods.26 The CSRC Code goesfurther to foster shareholder activism by providing that vot-ing through proxy is valid (but voting by mail is usuallynot), that cumulative voting27 shall be adopted by compa-nies whose controlling shareholder owns 30% or greater ofthe shares, and that shareholders “can protect their lawfulrights and interests through civil litigation in accordance withthe law.”28

Notwithstanding the emphasis given to voting rights bythe law, the shareholder meeting is viewed as little more thana rubber stamp. Special shareholder meetings are rare. Asfor annual meetings, more often than not insider-controlledmanagers set the agenda, decide what information to dis-close, and dominate the voting process. It has even happenedthat a firm’s management succeeded in precluding otherwisequalified individual shareholders from attending an annualmeeting.29 Knowing that their votes will have little or noimpact, small individual shareholders either vote for what-ever the management recommends or, far more frequently,ignore annual meetings completely. It does not matter thatstudies report the finding of a causal link between corporateperformance and governance,30 or that the authorities repeat-edly call for “rational” investment behavior. Given the envi-ronments they face, shareholders are indeed acting quiet ra-tionally.

The newly adopted cumulative voting rules by the CSRC

A view of the Bund in Shanghai.


Spring 2003

are commendable, but there are serious questions that needto be answered. First, controlling shareholders may easilycircumvent the rules by simply reducing the size of the board– the Company Law allows for as few as five directors. Evenif minority shareholders manage to put on board their electeddirectors, it is still difficult to form a general judgment abouthow much extra protection they can get. Minority sharehold-ers’ director-representatives may create a certain balance andpossibly even some contention in the boardroom, but dis-sent does not necessarily produce constructive dialogue thatwould benefit corporate performance.Moreover, at the end of the day, suchdirectors will have to realize that, withinsider directors at the helm, it is themajority shareholders who control theboard and decide how to reward (i.e.,pay) them. Apparently, the impact ofcumulative voting also depends onhow majority shareholders want totake advantage of minority shareholders and how effectiveother protective mechanisms, including the ability to sue,are.

Defrauded shareholders in China have not found courtsto be particularly helpful. Until last year, most courts wouldrefuse to hear any disputes involving securities issues, claim-ing they lacked jurisdiction over such suits. In January 2002,the Supreme People’s Court issued a notice officially open-ing the door, if narrowly, to plaintiffs seeking redress forlosses resulting from fraud in violation of securities marketdisclosure rules. All other plaintiffs will have to wait – prob-ably until the SPC feels comfortable with the concept of ad-judicating all types of stock-related suits or, alternatively,until the NPC makes new laws asking the courts to opentheir doors wider. The NPC perhaps also needs to consideradding a class action provision whereby shareholders willhave a right to sue as a group if the injury affects a numberof shareholders. The SPC has thus far insisted that the “jointaction” (gongtong susong) device under the Civil ProceduresLaw refers only to an action by a group of a fixed number ofplaintiffs; in practice, courts tend to impose various local-ized restraints on the filing of even such joint actions. Thisis unfortunate for both the courts and the investors. Judgeswaste too much time and energy on hearing separate or re-peated allegations against the same defendant for the samecause of action, while the extra trouble that would otherwisebe saved through class action inhibit countless shareholdersfrom moving forward, thus essentially depriving them of theirrights of action.31

CONTROL MARKET AND OTHER CONSTRAINTS

The market for corporate control, the hostile takeoverin particular, is sometimes viewed as a clumsy way to disci-pline managers because such changes to a corporation in-evitably incur heavy costs but do not always reflect themarket’s desire to weed out mediocre managers.32 Nonethe-less, the promise to indirectly monitor corporate performanceand partly substitute for weak direct shareholder oversight33

makes a control market an attractive idea to China’s regula-tors. The obstacles to the development of such a control

market, though, are less legal than practical. The recentlyenacted CSRC Administrative Measures on Purchase ofListed Companies provide a roadmap for basic forms of cor-poration combination through stock swap or stock purchase.Although the fact that controlling stakes in about one-thirdof all listed companies have to date changed hands mightsuggest otherwise, an active control market has yet to exist.This is because nearly all successful changeovers were car-ried out through some sort of government-arranged off-mar-ket transfer of state shares. Meanwhile, most of the hostile

takeover attempts have thus far failed.The commonly cited reasons are gov-ernment interference and controllingshareholder hegemony. The first con-cerns the target company’s non-trad-able state shares, the transfer of whichnormally has to go through a formi-dable bureaucratic process. The sec-ond reason raises more interesting

questions. In a number of thwarted takeovers, the target firmswere able to win the defense battles simply because of theunchecked power of their controlling shareholders: some con-trolling shareholders managed to adopt poison pills – tacticsdesigned to avoid a hostile takeover – in the firm’s charter;others succeeded by defeating the acquirer’s attempt to calla special shareholder meeting.34 Therefore, as far as the en-trenched managers are concerned, they have little practicalreason – at least for the time being – to fear losing controlthrough takeover or accumulation of shares by a marketraider.

Several other common constraints on managerial dis-cretion are weak in China’s corporate governance structure.Creditor monitoring of China’s public companies is at bestminimal. State-controlled corporations, with cheap debt fi-nancing still readily available from state-owned banks, sel-dom take seriously their obligations to repay loans, let alonepay heed to bank supervision, whereas banks and govern-ments are wrestling with the problem of mountains of non-performing loans.35 With respect to the risk of bankruptcywhich might otherwise threaten firms that fail to meet theirdebt obligations, such risk remains negligible in China – theprimary reason being concern about the likely turbulent con-sequences following the demise of SOEs. As for a brisk la-bor market for competent managers who might exert pres-sures on incumbents, such a market has yet to be developed;but even if replacements were in good supply, it would nothelp unless a misbehaving CEO actually feared being re-placed.

PROPOSALS AND SUGGESTIONS

Clearly, state influence on (and interference in) publiccompanies is among the root causes of the problems notedabove. To address this issue, the key appears to be to de-crease state ownership of public companies. Authorities havelong considered selling off state shares, but failed to moveforward for fear of paralyzing the highly volatile market.36

However, the disposal of state shares must be accomplished.Alternative approaches might include the divestiture of thoseshares to state banks that are already creditors of those cor-

Notwithstanding the emphasisgiven to voting rights by the

law, the shareholder meeting isviewed as little more than a

rubber stamp.


porations. This proposal would serve multiple purposes. First,because the banks are state-owned and enjoy considerablepolitical clout, the transfer of ownership from the state tothe banks will less likely cause a crisis of investor confi-dence. More importantly, it will probably also prevent theunbridled plunder that might otherwise take place if con-trolling stakes are directly acquired by private parties, likethe “Kleptocrat looting” that happened in Russia under theloans-for-shares regime.37 Second, if indeed state banks donot strip corporate assets through self-dealing, the role switchof banks from creditors to sharehold-ers will create the potential for banksto directly contribute to better corpo-rate monitoring. This is because a bankis more likely to be active in gover-nance because it is for-profit and there-fore may be more concerned than thegovernment about corporate perfor-mance. Finally, if coupled with lifting the ban on thetradability of state shares, this proposal would also makefirms more responsive to market demands, because, with all(or most, depending on the amount of shares actually trans-ferred) of their stocks circulating in the market, managerswould have to be more serious about fluctuations in shareprices.

The biggest uncertainty about the aforementioned pro-posal, though, comes from the problem it intends to solve:state interference. Being state-owned, banks may not haveadequate incentives to truly embrace the role of active par-ticipants in corporate governance.38 Therefore, to addressthe issue of state shares is no easy task. Nevertheless, solv-ing other state interference problems will be even more chal-lenging. For instance, it may take years of struggle to severthe links between the CSRC and the two stock exchanges soas to let the latter play more active self-regulatory roles andto create competition between them. Much the same is truewhen it comes to giving Chinese nationals opportunities toinvest in foreign capital markets so as to bring valuable com-petition into domestic markets. More broadly, tight state con-trol over the legal system is a principal reason why the sys-tem remains superficial and shows little concrete concernfor private investment after tens of thousands of laws andregulations have been issued over the last two decades.

As for corporate law, the precision of the laws discussedabove should be increased so as to leave less room for twist-ing and make better enforcement possible. There is prob-ably also the need to make new laws setting forth more con-crete institutions to motivate independent directors (such aspaying them in stock options), empower shareholders (suchas encouraging the development of and vesting substantialdecision making power in large outside shareholders), as wellas give managers and controlling shareholders incentives toobey the rules even when they could get away with ignoringthem.39 Also needed are laws authorizing a more decent en-forcement infrastructure. The augmentation of the CSRC’senforcement capacity is of special significance, given theweak shareholder monitoring and the non-existence of self-regulatory organizations to combat corporate misbehavior.More vigorous enforcement of the fairly elaborate disclo-sure rules under the Securities Law by the CSRC would work

to compensate shareholders for their powerlessness in exer-cising their voting rights under the Company Law. If indeedthe CSRC becomes capable of better ensuring the quality ofthe information divulged by public companies, individualshareholders could make more informed liquidation deci-sions.

However, writing good laws can take years and build-ing good institutions takes decades.40 To be sure, a moveaimed at strengthening the CSRC’s capacity to fight securi-ties fraud does not necessarily require new lawmaking, as

such a job would be well within theState Council’s legal authority. Nev-ertheless, the job is easier said thandone. To make the CSRC a strongerenforcement machinery would entail,to say the least, the recruitment of morecapable people by offering more de-cent pay than can be currently afforded

by the government, and, logically, the shedding of theCSRC’s current function of approving public offerings sothat the agency can focus more on regulatory and enforce-ment activities.41 However, such a proposal would require atleast amending the Securities Law, a job perhaps as difficultas making a new law, and lots of political maneuvers withinthe government.

In contrast, shareholder suits might hold particular prom-ise for the purpose at hand in the current Chinese context,especially in view of the fact that the immediate task forChina’s corporate governance is more monitoring of insid-ers to ensure that they do not steal the company’s value frominvestors, and less monitoring management performance toensure that a company maximizes that value.42 Indeed, amongall the defects of China’s corporate world, perhaps the mostinvidious is that a crooked manager has virtually no fear ofbeing sued.

Shareholder suits generally fall into two categories, al-though the distinction between the two can sometimes behazy: (1) direct suits, i.e., actions brought on the shareholder’sown behalf or on behalf of a class of shareholders for injuryto their individual interests; or (2) derivative suits filed onbehalf of the corporation for injury done to the corporation.For the purpose of protecting minority shareholders and curb-ing manager misbehavior, this paper recommends thatChina’s reformers should focus on the full legalization ofdirect suits, but refrains from recommending the adoptionof American-style derivative suits, in spite of the enthusi-asm about the latter among Chinese commentators.43 For onething, there is not yet clear evidence that derivative suits canbenefit anyone (except perhaps plaintiffs’ attorneys). In fact,a number of empirical studies in the US have shown “thatderivative actions do little to promote sound managementand often hurt the firm by diverting the managers’ time fromrunning the business while diverting the firm’s resources tothe plaintiffs’ lawyers without providing a correspondingbenefit.”44 To be sure, there is no evidence that the directsuit is an effective tool for aligning shareholders’ interestswith managers’ incentives either. But given the fact that cor-porate insiders are extraordinarily powerful and that minor-ity shareholders’ voting rights are all but useless, the moreurgent task appears to provide an option other than liquida-

Tight state control over thelegal system is a principal

reason why the system remainssuperficial.


Spring 2003

tion for China’s almost powerless small shareholders to rem-edy injuries done to them personally and in the meantimepunish crooked managers and deter potential ones. Share-holders suffer injuries as individuals and therefore shouldbe able to bring direct actions on their own behave againstthe culprits.

To begin with, among all the plausible suggestions, thismeasure probably requires the least change to the existinglegal and institutional framework. It would not necessarilydemand tough political maneuvers, aswould, for example, overhauling theCSRC or privatizing the two stock ex-changes. Nor does it require higherstandards of government capacity andhonesty. New lawmaking does not ap-pear necessary. In fact, the SPC hasalready taken the first step by allow-ing the hearing of disclosure fraudcases. What needs to be done is simply to expand the courts’subject matter jurisdiction to embrace all securities fraud andcorporate governance-related cases that directly hurt share-holders. Although such a move may encounter resistancebecause of the demand placed on judges in terms of exper-tise and experience, a solution might be to grant such juris-diction only to certain higher-level courts, if extra trainingfor judges will not work.

Best of all, though, the strength of the shareholder suitsolution lies in the fact that, as an accountability mechanism,it breaks away from the common top-down reform patternin China; once implemented, the incentive implied in a sucha mechanism is not legal coercion or governmental motiva-tion but self-interest. Disgruntled defrauded investors willact of their own accord. The fact that some 900 cases werefiled nationwide within months after the SPC gave the per-mit for hearing disclosure fraud cases in January 2002 of-fers a strong testimony to the willingness on the part of share-holders, and the eagerness of China’s newly minted army ofattorneys, to seek justice.45 After all, individual investors inChina hold alarmingly high stakes in their shareholdings:on average, individual shareholders invest up to 50% of theirhousehold assets in stocks and some even purchase sharesusing borrowed money.46

For the shareholder suit to be truly effective in combat-ing corporate wrongs, the device of class action has be toemployed. Actions against a corporation for fraud and re-sulting losses characteristically involve a large number ofclaimants. Class action is more efficient than individual ac-tion, since the court can hear one case rather than hundredsor thousands of similar cases. Without such convenience,dealing with a securities fraud suit can be extremely burden-some – not only for the litigants but for the court system aswell. Repeated litigation of the same claims arising out ofthe same occurrence, as happened in some cities last year,47

would exhaust the already-strained resources of the judiciary.Worst of all, it would discourage grieved shareholders frombringing wrongdoers to court, thus gravely limiting the im-pact of shareholder suits on monitoring corporate activities.Class action can also help achieve better justice by over-coming the inequality of the means for litigation betweenmore politically favored and powerful corporations and pri-

vate plaintiffs. In addition, to adopt class action in China’scivil procedural rules will not require extensive legislation:all that is needed is for the SPC to modify its current inter-pretation of “joint action,” already in the Civil ProcedureCode, to include situations where the plaintiff represents agroup with an unspecified number of members.

The effectiveness of China’s court system, which suf-fers from incompetence, corruption, and lack of indepen-dence remains a grave concern.48 It would be best if corpo-

rate wrongs could be cured in an effi-cient fashion so that dishonest corpo-rate managers could quickly learn theirlesson. But for this to happen, China’slegislature would need to better articu-late the boundaries of the responsibili-ties of the judiciary, rather than allowthe courts to determine on their ownwhat types of cases to hear and how to

hear them. However, for the purpose at hand, a less thansatisfactory court system is unfortunate but not fatal. To somedegree, it is the ability of shareholders to sue, hence corpo-rate wrongdoers’ fear of being sued, that matters more.

CONCLUSION

The extensive debate in the US triggered by the Enronfiasco speaks strongly about the challenge of establishingeffective institutions for corporate governance. In China, sucha challenge is especially daunting due to the transitional na-ture of its economy and society: the complexity of the prob-lems involved defy a simple or quick solution. While to solveall the problems will take time, effort, and pain, as force-fully argued by some Chinese officials,49 those aspiring tobuild a sensible governance system can start, in the spirit ofChina’s gradualist reform, with the least challenging prob-lem first.

If it is possible to prioritize among the major gover-nance problems, the top priority should be the shareholder’sright to sue. In particular, the shareholder should be able tosue through class action, for all types of injury done to themby unscrupulous corporate insiders, not just those resultingfrom disclosure fraud. This solution is the least demandingmeasure among all the plausible proposals considered. Easieraccess to courts will give shareholders in China some trueprotection and the country’s stock market some real hopebecause of that protection. Allowing shareholder direct classaction suits would be extremely beneficial for Chinese cor-porate governance as a whole.

The strength of the shareholdersuit solution is that it breaks

away from the top-down reformpattern in China.


ENDNOTES

1 See e.g., John C. Coffee, “What Caused Enron?: A Cap-sule Social and Economics History of the 1990’s,” WorkingPaper No. 214, January 20, 2003, at http://ssrn.com/abstract_id=37358; and “Understanding Enron: It’s Aboutthe Gatekeepers, Stupid,” July 30, 2002, Working Paper No.207, at http://ssrn.com/abstract_id=325240.2 See e.g., Zhou Xiaochuan, Chairman of CSRC, ShangshiGongsi Zhili Jiegou de Gaijin (The Improvement of Gover-nance Structure of Listed Companies), 2001, available athttp://www.csrc.gov.cn/CSRCSite/searchnews.htm?news-title; C. Lin, “Corporation and Corporate Governance inChina’s Economic Transition,” Discussion papers/Instituteof Economics and Statistics Oxford, 2000. See also infranotes 3 and 4.3 See e.g., Yan Yiming, Touzizhe Baohu he Xianzhuang(Shareholder Protection and Current Situation); Lu Xiaonan,Gongsi Zhili yu Touzizhe Baohu (Corporate Governance andShareholder Protection); Guo Feng, Wanshan Falu Jizhi ShiBaohu Xiaogudong de Guajian (The Key to Small Share-holder Protection is to Improve the Legal System). All avail-able at http://61.129.103.17/tzzfw/congs/bh/02.htm.4 Supra.5 Supra note 2; see also Laura M. Cha, Vice Chairman ofCSRC, “The Future of China’s Capital Markets and the Roleof Corporate Governance,” April 18, 2001, available at http://www.csrc.gov.cn/CSRCSite/searchnews.htm?news_title6 William P. Alford, “The More Law, the More…? Measur-ing Legal Reform in the People’s Republic of China,” Au-gust 2000, Center For Research On Economic DevelopmentAnd Policy Reform, Stanford University, available at http://credpr.stanford.edu/publications/china_PubsList.html.7 This is also demonstrated by the fact that China’s equitymarket has since early 1990s been divided into A-shares(open only to Chinese nationals) and B-shares (open only toforeigners) so that the government can maintain some con-trol over the experiment. See also, Gao Xiqing, “The Per-ceived Unreasonable Man - A Response to Fan Liufang,”Duke Journal of Comparative & International Law, Spring1995.8 The number was 1,224 by the end of 2002. See CSRCStatistics Bulletin. Available at http://www.csrc.gov.cn/CSRCSite/tongjiku/199911/default.html9 Before the 1990s, savers who did not want to put all theircash income in bank accounts could only buy governmentbonds. Limited corporate bonds and insurance financial in-struments gradually became available in the late 90s. Goldwas allowed to trade in the private market not until last year.Real estate markets remain rudimentary. Chinese citizens stillhave no opportunities to invest outside of China.10 This term refers to the practice that an investor cares onlyabout the possibility that she can sell her shares at higherprice but not about how unreasonably high she paid for theshares initially. Such practice is more common in a volatilemarket characterized by more price fluctuations from whicha speculator expects to profit. In contrast, a buy-and-holdinvestor holds her shares for relatively longer terms in thebelief that share prices in general reflect firm value and willgo up in the long run. See, e.g., Burton G. Malkiel, A Ran-

dom Walk Down Wall Street (New York: W.W. Norton, 1999).11 Bernard S. Black, “Agent Watching Agents: The Promiseof Institutional Investor Voice,” UCLA Law Review, April1992.12 A recent survey finds that 97% of the individual share-holders either do not bother to exercise or view their rightsto monitor the corporation. It also finds that 78.6% of indi-vidual investors simply wants to trade for profits while only11.7% of them are interested in receiving dividends. ChenBin, et al, Zhongguo Gushi Gerentouzizhe ZhuangkuangDiaocha (A Survey on Individual Shareholders in China),p. 10, available at http://www.sse.org.cn/sse/yjkw/yjbg.asp13 See CSRC Enforcement Bureau, Chufa Gonggao ( Pun-ishment Announcement), available at http://www.csrc.gov.cn/CSRCSite/enfobur/encf/encfml.htm.14 Shi Zhengfu, Konggu Gudong, Guanlian Jiayi yuXiaogudong Liyi (Controlling Shareholders, Self-Dealing,and Small Shareholder Interests), available at http://61.129.103.17/tzzfw/congs/bh/02.htm.15 Articles 2 and 19.16 The SEC created a safe harbor from the proxy statementrequirement that permitted most communications amongshareholders so long as they did not actually involves a so-licitation for proxies. Robert W. Hamilton, “Corporate Gov-ernance in America 1950-2000: Major Changes but Uncer-tain Benefits,” Journal of Corporate Law, Winter 2000.17 CSRC and People’s Bank of China, Decree No. 12, Pro-visional Measures on Administration of Domestic SecuritiesInvestments of Qualified Foreign Institutional Investors(QFII). An English translation is available at http://www.csrc.gov.cn/CSRCSite/eng/enews/efi20021114.htm.18 Chairman of the board, according to the Company Law,serves as “legal person representative” and has the authorityto execute or sign off major corporate documents. This pro-vision is largely insignificant from the governance perspec-tive, although in practice it has created confusions and po-litical struggles between the chief executive and the chair-man in certain companies.19 This is similar to the states of Delaware, California andNew York in the US.20 Chen Chen, Shangshigongsi Shougou yu FanshougouWenti Tantao (An Inquiry into the Question of Listed Com-pany Acquisition), January 2003, available at http://www.sse.org.cn/sse/yjkw/db1.asp.21 Remarks by the Vice-Chairman of CSRC, October 22,2001, available at http://www.csrc.gov.cn/CSRCSite22 Ronald J. Gilson and Reinier Kraakman, “Reinventingthe Outside Director: An Agenda for Institutional Investors,”Stanford Law Review, April 1991.23 Independent directors usually receive an annual salary ofabout RMB 50,000 Yuan (roughly $6,000), quite handsomeby Chinese standards, but executive directors often receivesuch benefits as a company car or an apartment, which areusually not available to independent directors.24 See “Greenspan Blasts ‘Infectious Greed,’” The Wash-ington Times, July 16, 2002.25 Stefan Prigge, “A Survey of German Corporate Gover-nance,” in Klaus Hopt, et al., eds., Comparative CorporateGovernance - The State of the Art and Emerging Research(1998).


Spring 2003

26 CSRC Decree No. (2000) 58, May 18, 2000.27 This is a voting system designed to give minority share-holders representation on the board by allowing a shareholderto cast all her votes for a single position, as opposed to astraight voting system under which each share of voting stockcarries one vote for each position to be filled on the board.28 Articles 4, 9 and 31.29 The Company Law requires, quite reasonably, sharehold-ers as of the voting date to be qualified to attend the share-holder meeting and vote. But some firms make their ownrules regarding the proof of voting qualification intended toprevent minority shareholders from attending a meeting.30 For example, Paul Gompers, et al, “Corporate Governanceand Equity Prices,” forthcoming in the Quarterly Journal ofEconomics.31 Yan Yiming, Xujia Zhengquan Xinxi Jiufenzhong deTouzizhe Baohu Xianzhuang (Shareholder Protection in In-formation Disclosure Fraud Disputes), June 20, 2002. Avail-able at http://61.128.103.17/tzzfw/congs/bh/02.hm32 See Hamilton, supra note 15.33 Bernard Black and Reinier Kraakman, “A Self-enforcingModel of Corporate Law,” 109 Harvard Law Review 1911-1982 (1996).34 See Chen, supra note 19.35 By the end of 2001, the non-performing loans or NPLs ofChina’s four biggest state banks accounted for about 30% oftheir total outstanding loans. See “Bank Becomes First toReveal its Non-Performing Loan Ratio,” at http://www.china.org.cn/english/2002/Apr/31618.htm.36 The issue of state shares poses a dilemma. On one hand, itis acknowledged that further development of the stock mar-ket depends on at least some of those shares becoming trad-able. On the other, however, the confidence of shareholders,individual shareholders in particular, of state controlled firmsappears to lie in the fact that large stakes of most publiccompanies are controlled by the state. That is why, when in2002 the CSRC worked out a scheme to sell off some state-owned shares, the proposal caused turbulence in the marketand drove individual investors out of stocks. See, e.g., StevenShi and Drake Weisert, “Corporate Governance with Chi-nese Characteristics,” The China Business Review, Sept.-Oct.2002.37 Bernard Black, Reinier Kraakman, and Anna Tarassova,“Russian Privatization and Corporate Governance: WhatWent Wrong?” 52 Stanford Law Review 1731-1808 (2000),at 1767.38 cf, Peter Dittus and Stephen Prowse, “Corporate Controlin Central Europe and Russia - Should Banks Own Shares?”in Roman Frydman, et al. eds. Corporate Governance inCentral Europe and Russia. Volume 1, Banks, Funds, andForeign Investors (Budapest: CEU, 1996).39 Supra note 31.40 Supra note 22, at 1753.41 Sed Crest, “Inside the CSRC: Gao Xiqing,” China Law &Practice March 2000.42 Bernard S. Black, “The Legal And Institutional Precondi-tions For Strong Securities Markets,” 48 UCLA Law Review781 (2001), at 842.43 See Fang Liufang, Gudong Daiwei Susong de Yuanli Guizehe zai Zhongguo de Heyongxing (Derivative Suits: Principles,

Rules and Applicability in China), available at http://61.129.103.17/tzzfw/congs/bh/02.htm. See also, supra note3.44 Felzen v. Andreas, 134 F.3d 873 (1998). See also RobertaRomano, “The Shareholder Suit: Litigation Without Foun-dation?” 7 Journal of Law, Economics & Organization 55(1991); Reinier Kraakman, et al., “When Are ShareholderSuits in Shareholder Interests?” 82 Georgetown Law Jour-nal 1733, 1994, at 1733. Moreover, for the plaintiff-share-holder personally, she runs the risks (if she loses her case) ofbeing liable for court costs incurred by the prevailing party,or the security that she may be asked to post in order to pre-vent abuse of derivative suits. This raises the issue share-holder incentives to sue: facing the possibility of somethingto lose but the certainty of nothing to gain, it is doubtful thatan individual shareholder in China would be interested ininitiating such a suit, even with the encouragement from herentrepreneurial attorney (who is usually motivated by a con-tingent fee arrangement under which the attorney’s fee isoften a percentage of the recovery if successful).45 See 2002 Nianzhong Baodao (Annual report for 2002),Shanghai Zhengquan Bao (Shanghai Securities News), De-cember 21, 2002, available at http://www.cnstock.com/tebebaodao.46 See Chen, supra note 11, at 10.47 See Yan, supra note 3.48 See e.g., Qingjiang Kong, “Is China’s Judiciary Readyfor WTO Entry?” Harvard Asia Quarterly, Autumn 2001,Vol. V. No.4.49 See Gao, supra note 6.


HAQ: Where does securities regulation rank among the Chinesegovernment’s major priorities and which aspects of securities regulationare the government targeting in particular? Can you give us a quick over-view of current efforts by the Chinese government in drafting legislationin this area?

Neoh: Securities regulation is an integral part of the ongoing financialreforms which are taking place in China. Financial reforms are amongthe top of the priorities of the Chinese government, although not the verytop priorities, which include alleviating poverty and unemployment, andensuring social stability. There is an active legislative program whichincludes drafting of a Fund Management Law, a Futures Markets Law,and an amendment to the Companies Law. I think the pace will quickenin the next legislative session this month.

HAQ: What major problems are the securities laws in China designed tosolve and what is the main vehicle to achieving the solutions? For ex-ample, American securities law places a heavy emphasis on preventinginsider trading and fraud through a rigorous system of disclosure. In whatways does the Chinese system differ? How have its securities laws evolvedor been shaped to suit local needs?

Neoh: Securities laws in China are aimed at accurate disclosure, orderlymarkets and the prevention of systemic financial risks. The SecuritiesLaw passed in 1998, which came into effect on July 1, 1999, is an amal-gam of provisions not too different from the type of provisions whichexist in the US Securities Act of 1933 and the Securities and ExchangeAct of 1934. China modeled its Securities Law on Taiwan’s Securitiesand Exchange Law, which in turn was modeled after US federal securi-ties statutes.

There are several significant local features. One is the reservation ofthe appointment of the Chief Executive of Exchanges to the China Secu-rities Regulatory Commission (CSRC). As the front line regulator, stockexchanges require experienced staff and so it was thought that the CSRCmust have a hand in the appointment of the Chief Executive of the Ex-changes. In other markets, the securities regulator has a right of veto, buthere the CSRC has a right of appointment. Also under the extant systemof appointments, senior appointments in the stock exchange require ap-proval of the Chinese Communist Party Organization Department, andso the power in the Securities Law ensures that there is legal backing tothis power of appointment.

Another feature is the proscription of unlawful investment of mon-ies in the banking system in the securities markets. The Banking Systemwas deemed too fragile to be able to undertake a massive exposure to thesecurities markets, and so it was thought that controls must be put inplace. This was a sensible step since it was impossible to judge the devel-opment of the emerging market, and most markets do set controls be-tween banks and securities markets.

Finally, the term “securities” is narrowly defined to mean “companyshares and company bonds and such instruments that the State Councilwill deem to be a security.” As the final shape of financial regulation is

INTERVIEW WITH ANTHONY NEOH:INVESTING IN CHINA

BY HAQ STAFF

Anthony Neoh is Chief Advisor to the ChinaSecurities Regulatory Commission (CSRC) andwas Chairman of the Hong Kong Securities andFutures Commission (HKSFC) from 1995 to 1998.In July 1997, he was made a member of the HongKong Basic Law Committee by the StandingCommittee of China’s National People’sCongress. From 1969 to 1979, he held variousdirectorate positions in the Hong Kong civilservice, including Assistant Director of theIndependent Commission Against Corruption,and was a member of the private Bar from 1979to 1995. He was a Deputy Judge of the High Courtin the Hong Kong Supreme Court and was namedSenior Counsel in 1990. He has been a visitingprofessor at Harvard Law School and at China’sZhongshan, Peking and Tsinghua Universities.


Spring 2003

still evolving, it was thought best to give a restricted defini-tion to the term “securities,” leaving it to the State Councilto widen the definition as the market evolves.

HAQ: How would you characterize average Chinese inves-tors and do the current securities laws adequately protectthem? What would you rank as the most urgent task in im-proving the securities laws and what measures would mostlikely be implemented in the long term?

Neoh: Average Chinese investors do not generally investaccording to company performance but according to shortterm swings in pricing; they follow the crowd. Only 8% ofthe turnover in the market is taken by institutional trades,and so individual investors and their psychology dominatethe market. In the year 2000, the market turnover was 500%,which means that every share in the market got turned over5 times that year (see table 1 below for comparisons withother countries).

The turnover rate has come down as the total turnoverin the market subsides. However, investment horizons con-tinue to be short. This phenomenon is often seen in emerg-ing markets where there is insufficient confidence in cor-porate performance and inconsistency of public policy.

Many of the companies in the stock market are state ownedcompanies which were listed based on performance per-taining to a period when they held either actual or naturalmonopolistic franchises. As the economy restructures, mo-nopoly positions become diluted resulting in lackluster per-formances. As a result, their majority shareholders resort toinjections of assets to bolster the performance of these com-panies. So, the worst performing stocks tend to get the mostfollowing after news of asset injections or “restructuring”as such actions are called.

The regulations regarding use of monies in the bank-ing system in investment in the stock markets are unclear.As a result, all loans secured by stocks become suspect,since it is difficult to differentiate between a loan used forfinancing business activities and a loan used to finance stocktrading (which would be margin trading). Thus, once thebanking supervising authorities clamped down on margintrading, the short term loans secured by stocks were notrenewed. Prices in the markets were pushed downwards,resulting in general loss of confidence. Furthermore, giventhat at least 55% of the market capitalization is owned bythe government, its announcement that it intended to sell itsstocks was not conducive to confidence, even though thesales will be indefinitely postponed. Whereas in other coun-

Table 1: Market Capitalization, Concentration and Turnover Velocity

Order Market MarketCapitalization($US billion)

Concentration TurnoverVelocity

1 NYSE 11,535 57.1% 87.7%2 Nasdaq 3,597 75.9% 383.9%3 Tokyo 2,962 70.5% 58.8%4 London 2,475 78.3% 69.3%5 Paris 1,350 86.2% 268.8%6 Frankfurt 1,186 45.3% 128.6%7 Toronto 756 75.5% 75.0%8 China

(HongKong)

624 65.4% 60.9%

9 China(domestic)

622 2.73% 500%

10 Taiwan 237 52.9% 259.3%

1. All figures (except the figures relating to China s domestic exchanges) are taken fromhttp://www.fiby.com, the website of the International Organization of Stock Exchanges.

2. The figures relating to China s domestic exchanges are taken from the CSRC s own database.3. All figures relate to the period 1 January to 31 December 2000.4. Concentration means the total turnover of the companies making up 5% of the total market

capitalization expressed as a percentage of the total turnover of the whole market for the year. Ifliquid market capitalization is taken into account, concentration is about 5% in China s domesticmarkets.

5. Turnover velocity is the total turnover for the year expressed as a percentage of the total marketcapitalization. Turnover velocity has in fact dropped from the 1996 high of 913% in Shanghai and1350.3% in Shenzhen.

Table 1: Market Capitalization, Concentration and Turnover Velocity

Order Market MarketCapitalization($US billion)

Concentration TurnoverVelocity

1 NYSE 11,535 57.1% 87.7%2 Nasdaq 3,597 75.9% 383.9%3 Tokyo 2,962 70.5% 58.8%4 London 2,475 78.3% 69.3%5 Paris 1,350 86.2% 268.8%6 Frankfurt 1,186 45.3% 128.6%7 Toronto 756 75.5% 75.0%8 China

(HongKong)

624 65.4% 60.9%

9 China(domestic)

622 2.73% 500%

10 Taiwan 237 52.9% 259.3%

1. All figures (except the figures relating to China’s domestic exchanges) are taken fromhttp://www.fiby.com, the website of the International Organization of Stock Exchanges.

2. The figures relating to China’s domestic exchanges are taken from the CSRC’s own database.3. All figures relate to the period 1 January to 31 December 2000.4. Concentration means the total turnover of the companies making up 5% of the total market

capitalization expressed as a percentage of the total turnover of the whole market for the year. Ifliquid market capitalization is taken into account, concentration is about 5% in China’s domesticmarkets.

5. Turnover velocity is the total turnover for the year expressed as a percentage of the total marketcapitalization. Turnover velocity has in fact dropped from the 1996 high of 913% in Shanghai and1350.3% in Shenzhen.


tries a privatization program would help develop a market,the investing public in China tends to see this as just an-other way for the government to get money from the mar-kets. The perception is that the markets are already small,with a finite pool of investors, and an overhang of a largeamount of unsold shares feels like Damocles’ Sword.

What is needed is a general strategy for divesting overtime which does not create immediate market impact andwhich improves accountability of corporate officers. Thatwould be a win-win strategy. The CSRC has shown a realdetermination to enforce and maintain good market stan-dards, which, along with help from the judiciary, will bringback confidence in the long run. How-ever, in the immediate term, the policyinitiatives must be to clarify the regu-lations regarding the use of monies inthe banking system and to explain ageneral strategy for the sale of gov-ernment-owned shares. One of the les-sons learned in all markets is that thesecurities markets do not stand alonefrom the rest of the financial system;the articulation of the role of the securities markets in thegeneral strategy for the reform of the financial system willenable the investing public to put the future of public policyin this area in perspective.

HAQ: Can you identify any strong political forces or inter-est groups at work that resist or advocate pending reforms?For instance, to what extent does shareholder activism existin China?

Neoh: Like all markets there are many different interestgroups pulling in different directions. The central issue iswhether the stock market can play the role it is supposed to.For example, can it efficiently allocate capital? Personalsavings in the banks have grown to just over 9 Trillion RMB,which translates into over 1 Trillion US dollars. Our de-posit interest rate is less than 2% per annum. This moneyneeds a higher yield to provide people with savings for theirretirement. Everyone wants these savings to go into the stockmarket but since the markets have proven to be so volatile,that is not going to happen, at least not in a big way. Marketreforms will have to recognize that there is a need for awider spectrum of investment instruments. Until then, thestock market is seen as a short-term proposition by mostinvestors and because of this kind of time horizon, investoractivism will not be seen as worthwhile by the investorsthemselves.

HAQ: How do the individual stock exchanges and variousChinese governmental institutions work together to enforcethe securities laws? What types of securities law violationsare most common and what difficulties does the governmentface in enforcement?

Neoh: There is good coordination between the stock ex-changes, the CSRC, the Public Security Bureau (i.e., the po-lice force) and the Public Prosecutor’s Office. Generally, thedifficulties come from the need for expertise in every inves-

tigation. The common types of suspected offenses are falsedisclosures, market manipulation and insider trading. Theinvestigators are generally overwhelmed and have to priori-tize. The courts are not skilled in adjudicating securities casesbut they will pick up this expertise over time. Thus, effec-tive enforcement will take time.

In addition, the Securities Law does not define civil li-abilities which are left to judicial interpretation. The SupremeCourt is due to announce a Judicial Interpretation of CivilLiabilities deriving from breaches of the Securities Law.Meanwhile, the courts have not yet ruled on any cases al-though a few have been filed.

HAQ: In January of this year, XieBaisan filed a lawsuit against theCSRC alleging mismanagement of thesecurities markets. Can you commenton the availability of private causes ofaction in China, and whether publicinvestors exercise any enforcement ca-pacity? Will such lawsuits becomemore common in China in the future,

and if so, will they hamper or advance the growth of China’scapital markets?

Neoh: The case has not yet been adjudicated; no doubt, thecourt is waiting for the Supreme People’s Court’s Interpre-tation. I believe this will help keep the market more honestand there will be more cases in the future.

HAQ: How do you think mainland China’s securities regu-lations and enforcement compare to those of other Asianactors, such as Taiwan, Japan and Singapore? To what ex-tent is there interchange between China and its neighbors inthe formulation of securities regulation policy? For instance,can you comment on the level of exchange between the regu-lators in Hong Kong and mainland China?

Neoh: Other Asian countries have legal systems with longerhistories, and a greater quota of experienced personnel inthe professions, the government and the judiciary. The presentChinese legal system only began to be reformed in the early1980’s, and so it is difficult to compare the effectiveness ofenforcement in China to other Asian countries. However,there is at least the same level of public and political scru-tiny; the actions of those involved in enforcement are lookedat and critiqued closely by the public and the national legis-lature. In terms of technical ability, the regulators in China –many of whom have come back from overseas training – aregetting better all the time. There is a string of memoranda ofcooperation between the CSRC and securities commissionsaround the world, and the CSRC actively participates in theExecutive Committee of the International Organization ofSecurities Commissions.

HAQ: What impact did the passage of the Sarbanes-OxleyAct and the Enron/Worldcom scandals in the United Stateshave upon securities law regulators and the investing publicin China, if any? Will this Act deter Chinese companies fromseeking financing from US capital markets in the future?

The CSRC has shown a realdetermination to enforce and

maintain good marketstandards which will bring back

confidence in the long run.


Spring 2003

Neoh: The Sarbanes-Oxley Act is a good example of mak-ing corporate officers more accountable; its underlying think-ing will be an example to all markets. China will not be anexception. In many ways China has in the Securities Law,Accounting Law and the Criminal Law criminal penaltiesthat are clear, along with the liabilities of the Chairman ofthe Board, the directors, and the CFO. The institutional fea-tures of the Sarbanes-Oxley Act, such as the AccountingOversight Board, in some ways already exist in China, withthe Finance Ministry playing the role of a statutory over-sight body. What is different is the level of enforcement.Investigators are less effective in China than the US and theprofessions are less sophisticated, and so a lower level ofenforcement effectiveness prevails.

The Act will not be a deterrent to Chinese companiesseeking financing in the US, as shown by the fact that quitea few Chinese companies are preparing for listing in the US.The Chinese firms which list in the US are advised by inter-national investment banks and international law firms whichhave decades of experience in the capital markets. The man-agement of these firms naturally get much more detailed ad-vice on compliance as well as investor relations, since theirinvestors are institutional investors. Firms listing in the Chi-nese domestic markets cater to individual investors, so theytend to be less sophisticated in their presentations. Prospec-tus requirements are also less detailed, involving much lesslitigation-proof boilerplate than their US counterparts.

HAQ: How open are the Chinese securities markets to for-eign investors?

Neoh: At the moment, only B shares (shares traded in HKor US dollars which foreigners or locals with foreign cur-rency can buy or sell) are available. The Qualified ForeignInstitutional Investors Scheme has just been launched toallow such investors to invest in the A shares market. TheScheme is modeled on a similar plan in Taiwan and is de-signed to introduce a set of investors who have tradition-ally looked to fundamentals as investment criteria.

HAQ: How do you see securities markets and regulationchanging in China in the next few years and in the long termas the investing public matures?

Neoh: The Chinese securities markets took the second step(the first, not too successful step, being B shares) to open-ing to the world by the system of Qualified InternationalInstitutional Investors. It will begin to mature as it becomesan international market where investment horizons tend tobe longer and more geared towards consistent corporateperformance.

The above represents the personal views of Anthony Neoh,SC, member of the Hong Kong Bar, and does not necessarilyrepresent the views of any organization.

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The Chinese economy has experienced spectacular growth since itstarted economic reform and the open-door policy over 20 yearsago. The rapid rise of China is casting a large shadow over its

ASEAN neighbours to the south, many of which have economies thatcompete with China in attracting foreign investment and in exportingmanufactured products to the same third-country markets. However, thereis a complementary angle to China’s economic growth, which can presenta huge opportunity for ASEAN by operating as a new engine of eco-nomic growth for the ASEAN region. One reason for this optimism isthat China is already a growing market for ASEAN’s exports of primaryand manufactured products. Another reason is that the recently signedFTA (free trade agreement) between China and ASEAN (which can bringabout greater economic integration between China and ASEAN) will inthe long run increase the region’s trade and investment to the benefit ofboth sides. However, it is important to point out that some ASEAN econo-mies need to undergo structural adjustment before they can reap the ex-pected FTA benefits. In the short run, ASEAN economies, being muchsmaller than the Chinese economy, are likely to incur the higher costs ofstructural adjustment. Finally, it is worth speculating on the future impactof the FTA agreement on the China-ASEAN relationship; doing this nec-essarily entails a brief discussion of the general reactions on the part ofASEAN countries to China’s rising influence, both economic and politi-cal, in East Asia.

THE ECONOMIC RISE OF CHINA

China’s economy grew at an average rate of 9.5% for the period of1978-2002. Whereas the 1997 Asian financial crisis brought down manyAsian economies, China was hardly affected by the crisis as it continuedto grow at 8.8% in 1997 and 7.8% in 1998. More recently, while eco-nomic growth in most of Asia has been falling to low or negative ratesand the world economy at large is creeping into recession, China’seconomy alone is still steaming ahead with strong growth. China chalkedup 7.3% growth for 2001 and 8% for 2002.1

China has been much less affected by the global economic down-turn, mainly because over 80% of China’s economic growth is gener-ated by domestic demand (i.e., domestic consumption and investment).However, China’s exports have also been growing rapidly, at an averagerate of 17% for the past two decades, from US$9.8 billion in 1978 toUS$326 billion in 2002. By 2002, China had become the world’s 4th

largest exporter, after the US, the EU, and Japan.2 For foreign directinvestment (FDI), China has become the world’s most favoured destina-tion in comparison with all other developing countries since 1993. From1988 to 2001, China’s realized FDI grew at an average rate of 23% perannum. By the end of 2002, China had attracted a total of US$621 bil-lion in FDI. In fact, China has regularly captured about half of all FDI inAsia. Not surprisingly, over 80% of the world’s 500 largest companieshave set up businesses in China.3

In all, China’s total nominal GDP in 2002 exceeded 10 trillion yuan(US$1.2 trillion) – or, more than twice the combined GDP of Indonesia,

THE RISE OF CHINA: BANE OR BOON TOSOUTHEAST ASIA?

BY JOHN WONG

John Wong is Research Director of the East AsianInstitute (EAI) and ex-Director of the Institute ofEast Asian Political Economy (1990-96) at the Na-tional University of Singapore. Author of over 10books and numerous articles on the developmentof East Asian economies, Wong’s books includeThe Political Economy of China’s Changing Rela-tions with Southeast Asia (1986) and (with NahSeok Ling) China’s Emerging New Economy:Growth of the Internet and Electronic Commerce(2001).


Spring 2003

Malaysia, the Philippines, Singapore and Thailand. Chinais already the world’s sixth largest economy. In terms ofpurchasing power parity (PPP), the Chinese economy to-day is already the world’s second largest after the US – oneneeds, of course, to be aware of the problem of overstatingChina’s real GDP by the PPP measure.4

Indeed, as a result of its rapid industrialization, Chinahas fast become the world’s foremost manufacturing base.In 2001, China produced 163 million tons of steel, 40 mil-lion sets of colour TVs, 13 million refrigerators, 18 millionair conditioners, 2.7 million automobiles and 8 million PCs.5

In 2001, China surpassed the US as theworld’s largest mobile phone market.By 2002, China’s registered Internetusers reached 59 million to form theworld’s second largest “Web popula-tion.”6

Accordingly, the meteoric rise ofChina’s economy has suddenly be-come a “hot” topic in international and regional media.7

Many Asian commentators are concerned about the emer-gence of China as a potentially disruptive force to Asian eco-nomic growth. Others even point a finger at China for theirown economic woes. Even the Japanese have started to showanxiety over China’s recent dynamic industrial expansion.The famous Japanese economist Kenichi Ohmae even useda sensational title, “Asia’s Next Crisis: ‘Made in China,’” totalk alarmingly about the rise of China.8 According to Japa-nese estimates, about one in two of the world’s motorcycles,one in three of the world’s air-conditioners and one in fourof the world’s colour TVs are now manufactured in China.China is indeed already producing more cell phones, moredesktop computers and more DVD players than Japan.9 Notsurprisingly, the smaller Southeast Asian economies arewatching the rise of China and its geopolitical implicationswith apprehension.

CHINA’S DYNAMIC GROWTH FROM A REGIONAL PERSPECTIVE

China’s economic performance in the past two decadeshas been breathtaking. Viewed in the overall Asia-Pacificcontext, however, China’s hyper-growth is actually not soexceptional. Nor is it unprecedented, as many other Asianeconomies have at one time or another also experienced suchhigh growth.

East Asia is commonly defined to comprise Japan,China, the four Newly Industrialized Economies (NIEs) ofSouth Korea, Taiwan, Hong Kong and Singapore, and thefour Association of Southeast Asian Nations (ASEAN) ofIndonesia, Malaysia, the Philippines, and Thailand – theoriginal ASEAN members. Situated on the western rim ofthe Pacific, many of these economies have displayed dy-namic growth for a sustained period until 1997 when theywere hit, in varying degrees, by the regional financial crisis.In a well-known study, the World Bank referred to this highgrowth phenomenon as the “East Asian Miracle.”10

Japan was the first non-Western country to become in-dustrialized. Its high growth began in the 1950s after itachieved post-war recovery, and its growth momentum con-tinued through the 1960s and much of the 1970s. Japan’s

economic growth engine was initially based on the export oflabor-intensive manufactured products, but it was soon forcedby rising wages and increasing costs to shed its comparativeadvantage for labor-intensive manufacturing in favour of thefour NIEs, which started their industrial take-off in the 1960s.These four NIEs, once dubbed “Asia’s Four Little Dragons,”for a time constituted the most dynamic Asian economies,as they sustained near double-digit rates of growth for threedecades, from the early 1960s to the 1980s.

By the late 1970s and early 1980s, high costs and highwages had also caught up with these four NIEs, which had

to restructure their economies towardsmore capital-intensive and highervalue-added activities, by passing theircomparative advantage in labor-inten-sive products to the late-comers ofChina and the four ASEAN economies.Thus, China and some ASEAN econo-mies were able to register high growth

in the 1980s and the 1990s. Some Japanese scholars like todepict this pattern of development in Asia as the “flyinggeese” model.11 (See Table 1.)

Suffice it to say that China’s economic growth fits inquite well with this overall growth pattern in the Asia-Pa-cific region. In a broad sense, China’s dynamic economicgrowth since 1978 has interacted positively with many ofthese high-performance economies to each other’s advan-tage. On the one hand, China has been able to harness theregion’s trade and investment opportunities to facilitate itsown economic growth. At the same time, China’s growingeconomic integration with the region also provides new op-portunities to enhance the region’s overall growth potential.In the short run, however, the rise of China may produce adisruptive impact on its neighbouring economies.

ASEAN ECONOMIES LOSING DYNAMISM

The Association of Southeast Asian Nations was formedin 1967 by Indonesia, Malaysia, the Philippines, Singaporeand Thailand to promote regional cooperation. Some 32 yearslater, ASEAN encompasses all ten Southeast Asian coun-tries after having admitted Brunei in 1984, Vietnam in 1995,Laos and Myanmar in 1997, and finally Cambodia in 1999.Even though many ASEAN countries are currently facingeconomic difficulty, politically ASEAN remains one of theworld’s influential regional groupings.

Most discussion of “ASEAN” is limited to the five origi-nal founding members of ASEAN, the so-called “ASEAN-five” (and sometimes the “ASEAN-four” as Singapore isgrouped under the “NIEs”). This is because newer mem-bers like Brunei, Cambodia and Laos are very small in termsof both population and per capita income, while Myanmaris barely open for economic interactions with other coun-tries and Vietnam is still in transition toward the marketsystem.

Indonesia is the largest country in ASEAN whileSingapore is the most developed economy. Indeed,Singapore’s per-capita income in 2000 at US$25,000 rankedthe ninth highest in the world, just below the US.12 OtherASEAN countries like Malaysia, Thailand and the Philip-

Viewed in context, China’shyper-growth is neither

exceptional nor unprecedented.


pines have clearly become middle-income economies, withtheir economic growth mainly driven by manufactured ex-ports, as can be seen in Table 1.

In comparison, the other new ASEAN members, withthe exception of the tiny oil-rich Brunei, are low-incomecountries, economically underdeveloped and still heavilydependent upon primary-product exports for their economicgrowth. They are structurally much like the ASEAN-fivesome 20 years ago.13 Such diversity has always been themain feature of ASEAN as a regional grouping, which ischaracterized by sharp differences among member states interms of not just stages of economic development but alsohistory, culture, language and religion.

These ASEAN-five have experienced fairly rapid eco-nomic growth since the early 1970s under largely stable po-litical and social conditions (except for the post-Marcos Phil-ippines). As a result, the five economies have all success-fully industrialized. In particular, the ASEAN-four (whichwere originally resource-based economies, dependingheavily on the export of natural resources and primary com-modities for growth) have all become industrialized in thesense that their overall economic growth is now primarilyfuelled by industrial growth and manufactured exports.14 Inthe early 1980s, for instance, oil and gas still used to consti-tute about 80% of Indonesia’s total exports. By the late 1990s,as shown in Table 1, the share of manufactured exports in-creased to almost half of its total exports. For Malaysia, thePhilippines, and Thailand, manufactured products now ac-count for about three-quarters of their total exports.

In 1997, the ASEAN-five were struck by the “Asian fi-

nancial crisis,” causing their economic growth to halt. Bythe end of 1999, two years after the outbreak of the crisis,they bounced back in positive growth, in the form of a “V-shaped recovery” as a result of the recovery of their stockmarkets, increased exports and greater exchange rate stabil-ity.15 However, their recovery process was soon disrupted in2001 with the onset of the global economic downturn, bring-ing about a small second “dip” (Chart 1).

Nonetheless, the 1997 regional crisis left behind manypolitical and economic scars. Politically and socially, the crisishas altered the institutional condition of ASEAN economicgrowth. The crisis brought down the old regime in Indone-sia and started the democratization experiment. There werealso pressures on other ASEAN countries to open up theirpolitical systems. However, an economically backwardyoung democracy may find it difficult to galvanize its con-tending political and social forces for the single-minded pur-suit of economic growth. Economically, the crisis laid barethe structural flaws of the ASEAN economies and pointedto their urgent need for reform and restructuring, particu-larly banking reforms that will lead to better supervision andfinancial architecture.

Even the external environment of ASEAN’s economicgrowth has changed. In recent years, economic growth mo-mentum in the region has gravitated towards Northeast Asiaas a result of China’s economic resurgence. In particular, therise of China has presented ASEAN with formidable exter-nal challenges.

CHINA’S COMPETITIVE PRESSURES ON ASEAN

TABLE 1: PERFORMANCE INDICATORS OF ASIA PACIFIC ECONOMIES

Population(Mn)

GNP per-capita(US$)

PPPestimates ofGNP per-

capita (US$)Growth of GDP (%)

AnnualExportGrowth

(%)

Mfgexportsas % of

totalexports

Exportsas % ofGDP

2000 2000 20001960-

701970-

801980-

901990-2000 1997 1998 1999 2000 2001 1990-

20001999 2000

China 1,261 840 3,940 5.2 5.5 10.1 10.3 8.8 7.8 7.1 8.0 7.3 15.6 88 26

Japan 127 34,210 26,460 10.9 4.3 4.1 1.3 1.0 -2.5 0.8 2.3 -0.4 4.6 94 10.8

NIEs

SouthKorea

47 8,910 17,340 8.6 10.1 8.9 5.7 5.0 -6.7 10.9 9.3 3.0 16.0 91 45

Taiwan 22 14,188 n.a. 9.2 9.7 7.9 6.3 6.7 4.6 5.4 5.9 -1.9 7.9 n.a. 55

Hong Kong 7 25,950 25,660 10.0 9.3 6.9 4.0 5.0 -5.3 3.0 10.5 0.1 8.4 95 150

Singapore 4 24,740 24,970 8.8 8.3 6.7 7.8 8.5 0.0 6.9 10.3 -2.0 11.2 86 179

ASEAN-4

Indonesia 210 570 2,840 3.9 7.2 6.1 4.2 4.5 -13.2 0.9 4.8 3.3 5.4 54 39

Malaysia 23 3,380 8,360 6.5 7.9 5.3 7.0 7.3 -7.4 6.1 8.3 0.4 12 80 125

Philippines 76 1,040 4,220 5.1 6.0 1.0 3.3 5.2 -0.6 3.4 4.0 3.4 7.3 41 56

Thailand 61 2,010 6,330 8.4 7.1 7.6 4.2 -1.4 -10.8 4.4 4.6 1.8 9.5 74 66

Notes: (1) 1997-2001 GDP growth rates extracted from Asian Development Outlook 2002.

(2) Per capita GNP figure for Taiwan from Statistical Yearbook of the Republic of China, 2001.(3) Average annual GDP figures for Taiwan from 1980-90 and 1990-2000 from Statistical Yearbook of ROC, 2001.(4) 1998-2001 GDP growth rates for Japan represent real GDP growth rates.(5) Average annual export growth for Singapore calculated from data provided by EIU; that of Taiwan from Ministry of Economic Affairs website.

Sources: World Bank, World Development Report 2000/2001, World Development Report 2002; World Bank website – www.worldbank.org/data; World Bank Half-Yearly Report on East Asia, April 2002;Taiwan Ministry of Economic Affairs, http://www.moea.gov.tw; Asian Development Outlook 2002; EIU DataServices; Statistical Yearbook of the Republic of China, 2001.


Spring 2003

CHART 1: CRISIS AND PROLONGED ECONOMIC RECOVERY OF ASEAN-5

-15

-10

-5

0

5

10

15

1996 1997 1998 1999 2000 2001 2002*

GD

P G

row

th R

ate

(%)

China

Thailand

Philippines

Malaysia

IndonesiaSingapore

Notes: (1) *2002 growth forecast estimated by World Bank in its half-yearly report on East Asia. (2) Singapore's 2002 growth rate officially estimated to be 2.2%.

Source: World Bank , "East Asia Regional Update: Making Progress in Uncertain Times", 6 November 2002; Asian Development Outlook 2002 .

Indonesia

China

Singapore Malaysia

Thailand

Philippines

CHART 2: EAST ASIAN EXPORTS OF TEXTILES, CLOTHING & FOOTWEAR (TCF) TO US MARKET, 1990-2000

0

5

10

15

20

25

30

35

40

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Year

Per

cent

age

(%) S

hare

Source: US Census Bureau, US Department of Commerce.

China

NIEs

ASEAN-4


China’s rapidly growing economy will inevitably im-pact significantly on its neighbouring economies in the Asia-Pacific region, which absorb about 50% of China’s exportsand attract three-quarters of China’s FDI.16 Broadly speak-ing, China’s dynamic economic growth will produce bothpositive and negative spillover effects for the region. Japanand the four NIEs may be forced to give up their compara-tive advantage for many of their manufactured exports. Butthey can also capture the benefits of the growing Chineseeconomy by exporting high-tech products and by investing

in China. These East Asian economies will become moreclosely integrated with China.

However, China and ASEAN (with the exception ofSingapore) tend to be more competitive than complemen-tary at their present stages of economic development. In manyways, China’s dynamic economic growth has created strongcompetitive pressures for the ASEAN economies, which arevying for FDI with China as well as competing head-on withChina’s manufactured exports in the developed country mar-kets.17

Initially, China’s success in economic reform and de-velopment had produced very little impact on the ASEANcountries to its south. Sino-ASEAN trade was very smalland in fact constituted only a small proportion of each other’stotal trade. Even by the early 1990s, when massive FDI be-gan to flow into China, there was no evidence that Chinahad “sucked” in a lot of capital from the ethnic Chinese inSoutheast Asia.18

The picture has radically changed since the second halfof the 1990s. While many ASEAN countries have beenplagued by persistent economic crises and domestic politi-

cal instability, as mentioned earlier, China has been relent-less in its pursuit of economic modernization. This narrowsthe development gap between China and ASEAN. China’srapid economic development is fast leaving the ASEAN re-gion behind.

Specifically, the change in China’s export structure hasthe most serious implications for the ASEAN economies.When Deng Xiaoping opened up China in 1978, half ofChina’s exports were made up of primary commodities likemineral and agriculture products. Today, manufactured prod-ucts constitute about 90% of China’s exports. Before 1995,

traditional labor-intensive manufactures like textiles, cloth-ing and footwear (TCF) used to dominate China’s exportstructure (Chart 2). All developing economies have gonethrough the stage of exporting such traditional labor-inten-sive manufactured exports. Hence China’s TCF exports werenot much a real “threat” to ASEAN’s own exports, espe-cially since many of ASEAN’s TCF export items to devel-oped countries are protected by the Multi-Fiber Arrange-ment (MFA) system.19

In recent years, the composition of China’s manufac-tured exports has experienced significant changes markedby the rise of non-traditional items like machinery, electron-ics, and other hi-tech products.20 China’s rapid expansion ofsuch non-traditional exports is clearly posing serious chal-lenges for the ASEAN-four, which are directly competingwith China in third country markets, particularly the US.

As China is now a WTO member, Sino-ASEAN exportcompetition in such non-traditional items as electrical ma-chinery and electronics products is expected to grow evenmore intense in the future. As illustrated in Chart 3, althoughthe electrical and electronic exports of the ASEAN-4 and

CHART 3 EAST ASIAN ELECTRICAL & ELECTRONICS EXPORTS TO US MARKET, 1990-2000

0

5

10

15

20

25

30

35

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Year

Per

cen

tag

e (%

) S

har

e

Source: US Census Bureau, US Department of Commerce.

ChinaNIES

ASEAN-4

NIEs


Spring 2003

the NIEs combined are higher than China’s, China is rapidlytaking on these Asian competitors as evident in its increas-ing share of the US market for these products over the years.

In 1990, for instance, China’s share of the US electron-ics market was only around 2%, but this share increased to9.7% by 2000, comparable to 8.4% for Taiwan and 9.8% forSouth Korea, and higher than the ASEAN-4 countries – 9.2%for Malaysia, 1.0% for Indonesia, 3.0% for the Philippines,and 4.5% for Thailand. China is set to overtake both theNIEs (which are relocating their production bases to China)and the ASEAN-4 whose export competitiveness is beingrapidly eroded by China’s growing strength in these non-traditional items.21

What makes China different fromASEAN is the fact that China has amuch larger pool of both skilled as wellas non-skilled labor. China also has alarge domestic market for all sorts ofproducts, from high-tech to low-tech,to take advantage of the economies ofscale effect. With lower average andmarginal costs generated as a result of high-volume produc-tion, China is thus able to enjoy its natural cost advantagecompared to ASEAN and other smaller developing coun-tries. Furthermore, for both China and ASEAN, a high pro-portion of these non-traditional items are produced underOEM (original equipment manufacturing) arrangementswhereby large multinational companies use China (andASEAN) as a platform to process products for exports. Wheresharp cost gaps occur, these multinationals may simply cutback their production facilities in ASEAN and move themto China. Hence a decline of both ASEAN’s FDI and manu-factured exports.

COPING WITH THE RISE OF CHINA

Without doubt, China’s economy will continue to growunabated. In fact, China for its own political and social rea-sons needs to continue with high economic growth, not justto satisfy the rising material aspirations of the Chinese people,but also to maintain social stability and facilitate further eco-nomic reform. In particular, China’s present younger fourthgeneration leaders need good economic performance to le-gitimize their rule.

It may well be true to say that China today is not yet amajor economic threat to any Asian country. However, ev-ery ASEAN country should brace itself for the economicrise of China. To cope with the rising China, Asian govern-ments have to develop a more “positive” attitude. Just cry-ing wolf does not help. China is not the root cause of theirpresent economic difficulty, and their governments shouldnot use this as an excuse for not making the hard decisionsto carry out reform and restructuring.

For Japan, the rise of China seems to coincide with itssecular decline. Many Japanese would naturally find it diffi-cult to accept this, particularly since Japan is still techno-logically and economically so far ahead of China. By com-parison, South Korea and Taiwan seem more realistic in thesense that they have been quicker to embrace the rise ofChina. Thus, Korean and Taiwanese businesses are actively

re-positioning themselves to find new niches or new oppor-tunities in the expanding China market, and to work out newareas of complementation with China. In this way, the riseof China can be turned into a positive force for their mutualbenefit.

For ASEAN, the rise of China poses a real challenge.But some ASEAN countries have to put their house in orderfirst by restoring social stability. Average labor costs per hourin Malaysia and Thailand and even Indonesia are still higherthan in China. This explains why some ASEAN governmentsare really worried over the loss of their comparative advan-tage to China, even though China is opening itself up for

more ASEAN exports.22 In the shortrun, these ASEAN countries need toaddress the real issue of economic re-structuring. In the long run, they willhave to accept the rise of China as anew political and economic reality –in the future they may have to do soagain for the rise of India!

However, there is also a comple-mentary angle to the Sino-ASEAN economic relationship.As the Chinese economy continues to grow, it will also in-crease demand for exports from ASEAN, particularly for itsprimary commodities and natural resources. In fact, someASEAN countries, particularly Malaysia and Thailand, takea positive view that the rise of China also means the emer-gence of a potentially new locomotive of economic growthfor the region.23 In 2002, China imported much more fromASEAN than ASEAN from China, indicating that China canbe a huge potential market for ASEAN goods. Many ASEANcountries, particularly Malaysia, Thailand and Vietnam, alsowitnessed a sharp rise of tourist arrivals from China. Evenmore significantly, China’s outbound FDI to the ASEANcountries has been steadily increasing in the past few years.These trends are likely to intensify in the future. Singapore,too, embraces such a pragmatic view, as Prime Minister GohChok Tong declared in his 2002 National Day Speech:

“China’s rising does not mean Singapore declin-ing. Rather, an ascending China offers abundant op-portunities for Singaporeans to ride on its growth…If we view China as a threat, we will be immobi-lized by fear. If we see it as an opportunity, we willcome up with creative ideas to ride on China’sgrowth…”24

CHINA-ASEAN FREE TRADE AGREEMENT (FTA)

At the ASEAN-China Summit in November 2000, Chi-nese Premier Zhu Rongji proposed the creation of a freetrade area between China and ASEAN within 10 years. OnNovember 4, 2002, China and the ASEAN countries signeda landmark framework agreement in Cambodia to establishan FTA by 2010.25 The formation of the China-ASEANFTA signifies the creation of an economic region of 1.7 bil-lion consumers with a combined GDP of US$2 trillion. Itoffers an effective means for smaller ASEAN states to over-come their size disadvantage by pooling resources and com-bining markets. This will certainly lead to greater economicintegration between China and ASEAN, which will clearly

To cope with the rising China,Asian governments have todevelop a more “positive”

attitude. Just crying wolf doesnot help.


be a win-win situation for both sides. 26

In the short run, however, ASEAN has to deal with theinitial risks of the FTA in connection with the potential tradediversion effect and related structural adjustment.27 In gen-eral, the FTA scheme will give rise to uneven distributionof costs and benefits among different industries, differentsectors, and even among different ASEAN countries. Thismeans that adjustment costs are likely to be asymmetricalamong the ASEAN states, i.e., some will gain more thanthe others. Adjustment costs will be even more asymmetri-cal between China and ASEAN. Individual ASEAN econo-mies, being smaller, are likely to incur higher costs of ad-justment than China.28 As China is bracing itself for thechallenges arising from its WTO membership, its FTA ar-rangements with ASEAN will likely incur little additionalcost.29

After the initial process of adjustment, individualASEAN economies will need to develop their own nichesin their economic relations with China. With China con-tinuing its dynamic economic growth, opportunities willarise for the ASEAN countries to exploit China’s growingmarket so as to capture the spillover of its growth. Apartfrom its primary commodities, ASEAN’s resource-basedproducts will be in great demand in China. China is such avast and disintegrated market that East China, South Chinaand Southwest China individually can offer different op-portunities to ASEAN producers. Beyond merchandisetrade, FTA also promotes trade in services. China may gen-erally have good advantage in manufacturing because it canenjoy the economies of scale; however, this may not applyto many service activities. In fact, a lot of China’s serviceactivities, on account of their socialist legacies, are knownto be more backward than those in ASEAN.

Above all, as the FTA scheme is gradually phased inover the years, multinationals in the region will take stepsto restructure their supply chains and rationalize their pro-duction networks by taking China and ASEAN together askind of a single market. This will eventually lead to a redis-tribution of regional FDI as a result of the reshuffle of re-gional OEM facilities. In short, both trade and FDI in theregion will continue to grow under the impact of the FTA.This will certainly be a boon to both sides.

Politically, China will need to depend on the FTA tostabilize and improve its long-term relationship withASEAN. Successful implementation of this scheme willinevitably lead to a much more prominent Chinese politicaland economic presence in the region. Currently, the eco-nomic rise of China is already casting a large shadow overASEAN. Whether or not China will flex its political andmilitary muscles in the future is largely a matter of specula-tion. It is understandable that certain wary ASEAN statesare contemplating their evolving relationship with Chinawith some apprehension.

ENDNOTES :

1 See “GDP Set for 8% Growth,” China Daily (Beijing, De-cember 31, 2002); see also John Wong, “China’s Economyin 2002 and Outlook for 2003,” EAI Background Brief No.143 (Singapore: East Asian Institute, January 2, 2003).2 News article, accessed from http://news.Xinhuanet.com/fortune/2003-01/09/content_684846.htm website.3 “China Trade Surplus Adds up to US$13.3 Billion,” TheStandard (Hong Kong), July 12, 2002.4 World Bank, World Development Report 2000/2001(New York: Oxford University Press). Also, Mingpao(Hong Kong), September 20, 2000.5 National Bureau of Statistics, China Statistical Yearbook2002; article accessed at www.cinanews.com.cn/n/2002-02-06.6 China Daily, (January 21, 2003).7 China’s emergence as the world’s manufacturingpowerhouse after two decades of dynamic growth has invitedworldwide attention. The international media has recentlyportrayed China’s economic resurgence as an economicthreat. David Roche, a famous Wall Street economist,commented on China being a source of the current globalrecession with its mass production of a wide range of low-priced manufactured products for the world market. Earlierthis year, Japan’s Nikkei Weekly reported that China wassetting the pace in markets for commodities around the world.The Chinese media and academia have since come out todefend China’s position.8 “Asia’s Next Crisis: ‘Made in China’,” The Straits Times(Singapore, August 2, 2001).9 See “China takes production lead as foreign firms set upshop,” The Nikkei Weekly (August 6, 2001).10 The East Asian Miracle (New York: Oxford UniversityPress, 1994).11 The “flying geese” concept of development was originallycoined by a Japanese economist, Kaname Akamatzu, in “AHistorical Pattern of Economic Growth in DevelopingCountries,” Developing Economies, Vol. 1 (March/August,1962).12 World Bank, World Development Report 2000/2001 (NewYork: Oxford University Press).13 See John Wong, ASEAN Economies in Perspective: AComparative Study of Indonesia, Malaysia, the Philippines,Singapore and Thailand (London: Macmillan Press, 1979);see also John Wong, The Political Economy of China’sChanging Relations with Southeast Asia (London: MacmillanPress, 1984).14 Oil and gas used to constitute 80% of Indonesia’s exports;Malaysia’s exports used to be dominated by rubber, tin andpalm oil; Thailand used to depend heavily on rice and sugar;and the Philippines used to depend heavily on coconutproducts. See ibid.15 “Asia’s Astonishing Bounce-Back,” The Economist(August 21-27, 1999).16 International Monetary Fund, Direction of Trade Statis-tics Yearbook 2001 (Washington, DC, 2000).17 For further discussion of this topic, see Prakash Loungani,“Comrades or Competitors? Trade Links Between China andOther East Asian Economies,” Finance & Development (June


Spring 2003

2000).18 See John Wong, Southeast Asian Ethnic Chinese Invest-ing in China (EAI Working Paper No. 15, October 23, 1998).19 World trade in textile and apparel was previously governedby the MFA system, which permitted the use of quotaswithout compensation. On January 1, 1995, the MFA wasreplaced by the Agreement on Textiles and Clothing (ATC),which applies to all WTO members.20 John Wong and Sarah Chan, “China’s Rapidly ChangingExport Structure,” EAI Background Brief No. 85 (Singapore,April 9, 2001).21 For instance, China’s top electric appliance maker, Haier,has penetrated the US market to compete against entrenchedforeign firms on the basis of price and quality. It hasestablished a plant in the US to manufacture consumerelectronic products like refrigerators and air conditioners.See Far East Economic Review, March 29, 2001.22 “ASEAN Trade Accord Backfires,” The Asian Wall StreetJournal (December 2, 2002).23 This is actually happening now, as the most recent UNreport, “World Economic Situation and Prospects 2003,” ar-gues that China has become a “bit of an engine for the wholeAsian region” by picking up Japan’s slack. See “An enginefor Asian region,” China Daily (January 11, 2003).24 The Straits Times (Singapore), August 19, 2002.25 The framework agreement signed by the eleven nationstates sets out a road map for trade liberalization in goodsand services for most countries by 2010, and for the lessdeveloped ASEAN nations (namely Cambodia, Laos,Myanmar and Vietnam) by 2015.26 For further discussion of this topic, see John Wong andSarah Chan, “China-ASEAN Free Trade Agreement:Shaping Future Economic Relations,” Asian Survey(forthcoming in May/June 2003).27 Trade diversion occurs when members of a free tradegrouping, due to a lowering of tariffs or non-tariff barrierswithin the FTA, trade more among themselves than with non-member countries. Structural adjustments occur when intra-regional barriers are dismantled, given that industries expandin some countries and contract in others as they relocate inresponse to differences in factor endowments. The costs ofadjustment resulting from such relocation of economicactivity can be asymmetrical, since some economies incurhigher costs in the short run than others.28 China’s economy is much larger than the individualeconomies of the respective ASEAN countries; as such, it isable to absorb the adjustment costs relatively better than theASEAN economies, particularly when it is rapidly growingand developing.29 This is quite self-evident as China is restructuring itseconomy to meet the challenges of WTO membership. Chinahas already implemented structural reforms to strengthen itsdomestic industries to meet competition from foreigninvestment. In the long term, when the FTA between Chinaand ASEAN is realized within ten years, there will beconsiderably fewer additional costs for China, since it willhave already reformed most of its economy to better adjustto the challenges arising from its WTO accession.


By taking promising steps toward increasing personal freedom andopening itself up to the world under doi moi (renewal) reforms inthe mid-1980s, the Vietnamese Communist Party in the subsequent

years achieved impressive economic growth (defined as the quantitativechange in the scale of the economy, including investment).1 Althoughthese steps in recent years have been “one step forward and two stepsback,” World Bank analysts are optimistic that the current annual GDPgrowth of 7 percent since 2001 is an indication of a new phase ofsustainable economic growth and development.2

Because reforms have moved the country toward increasingintegration with the global economy, many Western politicians and analystshave assumed that improvements in economic life and greater freedomwill result. However, an inside-out, rather than outside-in, analysis showsthat this is not necessarily the case. This is because the Party’s impetus toreform is not driven by the need to attain sustainable economic growth orkeep up with the economic development in the region. Rather, it is drivenby the need to balance political stability and economic growth. Whencrises undermined the Party’s performance (as happened in the early1980s), leaders embraced reform under doi moi . However, whenexternalities of the reform affected political stability (as was the case inthe mid-1990s), leaders pulled the plug on reform.3 But stalling reformfor too long led to an economic downturn. Not surprisingly, to avoidpolitical instability, the Party had to come up with another program ofreform. The Party decided to integrate more thoroughly with the globaleconomy, but this time on its own terms. This policy of “globalization”has resulted in higher economic growth in 2001-2003 relative to the late1990s.

However, the policies behind the current growth, such as “tempo-rary” laws to meet the obligations of being a member in the global com-munity or the “strict-scrutiny test” (according to which any political ex-pression that is not in tune with the Party is deemed prosecutable), reflectthe Party’s attempt to obtain economic growth without increases in eco-nomic and political freedom. In fact, the current economic growth hasnot been accompanied by any increases in economic and political free-dom, as measured by both the Heritage Foundation and Freedom House.4

Economic and political theory provides strong reasons why a freereconomy (with secure property rights, freedom of exchange, and free-dom to enter and compete in markets) will grow more rapidly and consis-tently than those economies that are less free. Empirical study does in-deed show that increases in economic and political freedom lead to morerapid and consistent economic growth, and in some cases, more egalitar-ian outcomes.5 One major exception is China, which has registered im-pressive growth rates in recent years. China has experienced slight in-creases in economic freedom (according to the Economic Freedom of theWorld Report) but no increases in political freedom (according to Free-dom House).6 But whether China will become the only dictatorship toachieve continued economic power is still in dispute. For instance, itseconomic success, unlike the economic successes of South Korea andTaiwan, has given rise to greater income inequality and growing govern-

SUSTAINED ECONOMIC DEVELOPMENT ANDPOLITICAL REFORM FOR VIETNAM

BY LONG LE

An Assistant Professor of Political Science at theCalifornia State University-Bakersfield (CSUB),Long Le is also the Director of Tomorrow Vietnam-ese Forum-Policy Center at CSUB. Le’s researchfocuses on Vietnam’s socio-economic develop-ment, the Vietnamese American community, andrelations between overseas Vietnamese commu-nities and Vietnam. Le has authored articles in pe-riodicals published in both the United States andVietnam, such as The Washington Times, Associ-ated Press, Houston Chronicle, and Vietnam Bul-letin.


Spring 2003

ment corruption.7

Similar to China, Vietnam’s current economic growthis not accompanied by increases in economic and politicalfreedom. As a result, while the current growth is better thanno growth, this has been at the expense of the welfare andneeds of Vietnam’s people (who have learned to make dowith very little material possessions and political freedom),resulting in a growing income gap between the haves andthe have-nots. It is unlikely that such growth will enhancefuture growth and economic development. In the end, it ap-pears that the way out forVietnam in both a quantita-tive (economic growth) andqualitative (sustainable eco-nomic development) manneris through political reform.

It has been noted thatVietnamese citizens, as wellas other East Asians, are at-tracted by the “universal ap-peal” of personal freedomand dignity and of respon-sible government.8 EastAsian countries and their po-litical leaders who have al-lowed their citizens to incor-porate elements of libertyand democracy into theirown cultures are the samecountries that are experienc-ing sustained growth withrelatively egalitarian out-comes.9

Vietnam’s Communist Party, however, has not allowedthe country’s citizens to incorporate elements of freedomand democracy into their own culture. As a result, Vietnamdoes not have a political system in which its citizens canfreely develop and express their creative talents to the full-est.

Only by seeing increases in economic and political free-dom can one be optimistic about sustainable developmentfor Vietnam. This is most likely to occur if the VietnameseCommunist Party places priority on sustainable economicdevelopment over political stability and subjects itself to realelections, as opposed to merely pursuing greater internationaleconomic integration.10

THE NEXT ASIAN TIGER OR SIMPLY A PAPER TIGER?

A 2003 development report of Vietnam by the WorldBank and the Asian Development Bank forecasts that thecountry will record a healthy GDP growth of about 7 percentor higher in the coming years.11 The report argues thatVietnam may be entering a new phase of rapid economicgrowth, as in the 1990s when it was growing at 9 percent ayear. This forecast is based on the series of commitmentsand initiatives that the Party has made to accelerate thetransition to a market economy. Yet, the report admits thatthe pattern of growth will very much depend onimprovements in the quality of Vietnam’s governance.

According to official Vietnamese statistics, Vietnam’seconomy has been growing at 7 percent since 2001.12 Al-though its “official estimates of its GDP growth have beenconsistently above those [and widening] from the IMF [since1999],” said Barry Coulthurst from Australia & New ZealandBanking Group, Vietnam was still “the fastest growingeconomy in East Asia after China” in 2001-2002.13

Investors, however, are understandably cautious aboutVietnam’s ability to sustain its economic growth.14 Investorshad bought into the fever of the 1990s, believing that the

Party would unleash thecountry’s economic poten-tial. By the late 1990s, how-ever, that fever had turnedinto an economic downturn.The reason behind the down-turn was that Vietnam wasstill a Communist state, andthe Party lacked a strategy onhow to adapt to the globaleconomy. In choosing be-tween uncertain develop-ment and more stable devel-opment, foreign investors,unlike Vietnamese citizens,can, and did, choose the lat-ter – deciding to relocate toIndonesia and Malaysia.

Although Vietnam’seconomic downturn hadalready begun before theAsian financial crisis andthe crisis had a relatively

small impact, the crisis did not help its economy.15 Since thecrisis, the Party has made steady strides to make the worldnotice Vietnam again, as evidenced by its increasedinvolvement as an ASEAN member, its recent traderelationship with the US, and its appeal to join the WTO.

Is Vietnam serious this time in becoming the next Asianphenomenon? Delivering a speech on US relations with Viet-nam, US Ambassador to Vietnam Raymond Burghardt ac-knowledged that the Vietnamese Communist Party’s tightcontrol over its citizens’ lives has impeded economic devel-opment. Even so, the US Ambassador sees positive long-term trends for Vietnam such as “dramatic expansion in per-sonal freedoms, diminishing role of state control over theeconomy, development of a legal system and norms, andgrowing integration into the regional and international com-munities.”16

Ambassador Burghardt’s optimism can be traced to acommonly held view in Washington that Vietnam’s “newchapter” with its economy becoming more integrated withthe rest of the world will bring about improvements ineconomic life and greater freedom, which will lead toeconomic development.17 After his historic visit to the formerUS enemy, President Clinton similarly asserted that Vietnamwas on a “virtually irreversible” course toward prosperityand greater freedom. This view relies on the belief thatmembership in the global community exposes and conditionsVietnam to the “developed” norms and institutions conducive

Small-scale entrepreneurs are playing a vital role in Vietnam’snew economy.


to progress.This view in Washington was the reason many leaders

from both major US political parties in the past year(including Senators and former Vietnam veterans John Kerry,Massachusetts Democrat, and John McCain, ArizonaRepublican) have killed legislation that would restrict non-humanitarian aid unless Vietnam makes progress in humanrights. Legislation that would have derailed Vietnam traderelations renewal was similarly sidelined.

But, as David Lamb cautions, interpreting the motivesbehind Vietnam’s new chapter, perhaps much like the periodof the Vietnam war, is “like peeling the skin of an onion:You went deeper, layer by layer, butnever got to the core.”18

Here, an inside-out, rather thanoutside-in, analysis of Vietnam can beinsightful. Such analysis shows thatimprovements in Vietnam’s economywere not necessarily a result of greaterinternational economic integration andthat economic integration does notnecessarily bring about greater freedom. First, it was theexplicit political decisions made by the Party that pulledVietnam out of the World Bank’s group of 40 poorestcountries. The reform under doi moi in 1986 was motivatedby an economic crisis – over 70 percent of the Vietnamesepopulation was in poverty – that threatened to bring aboutpolitical instability. Doi moi reforms were said to contributeto growth by giving citizens more “personal” freedom, suchas allowing travel without having to get permission,encouraging family and small businesses, and “leasing” land-use rights to entrepreneurs, combined with providing moreaccess to outside capital through tourism and foreigncorporations.

At the same time, it was precisely the same explicitpolitical decisions made by the Party ten years later thatexplain why Vietnam today has not caught up with its neigh-bors. The Party feared that the doi moi reforms had pro-duced “social evils” (such as the import of Western indi-vidualism and Western capitalism) and exposed a numberof institutional problems (such as government corruption).Therefore, the Party, driven by the same fear of politicalinstability, called for a “time out” to rethink its reform pro-gram in order to avoid political instability. But by slowingdoi moi down, along with retaining obvious institutionalproblems – such as the dominance of incompetent bureau-cratic rule, the underdeveloped legal system, and govern-ment corruption – economic growth diminished in the pe-riod from 1997-1999 (according to the IMF, GDP growthwas at one point 4 percent). Foreign direct investment (FDI)also plummeted from a high of about $8.5 billion in 1995 toa low of $1.5 billion in 1999, and rose only modestly toabout $2.5 billion in 2002. While the region’s financial woesdid not help, the decline of FDI is mostly due to the fact that“the rhetoric of doi moi turned out to be mostly that – rheto-ric.”19 Even the Party has now accepted that its reforms inthe areas of foreign investment and legal framework havebeen lacking.20 In the face of increased competition for FDIfrom neighboring countries, Vietnam’s chances to recap-ture a high level of FDI lie in creating an “attractive force

for foreign enterprises” or starting a sequel to doi moi re-forms.21

Certain types of reform can better promote growth, andcertain types of government can promote growth more con-sistently. For Vietnam to achieve sustained growth it needsto integrate into the global community to benefit from mutu-ally advantageous trade. To realize all the benefits from glo-bal trade, Vietnam has to develop “a legal system and politi-cal order that enforces contracts, protects property rights,carries out mortgage agreements, provides limited liabilitycorporations, and facilitates a lasting and widely used capi-tal market that makes the investments and loans more liquid

than they would otherwise be.”22 Butbecause Vietnam is a one-party state,the commitments to reform “are notenforceable by an independent judi-ciary or any other independent sourceof power.”2 3 In addition, governanceproblems – such as an ineffective pub-lic administration, the preferentialtreatment of state-owned enterprises,

the lack of political competition and free press to induce andcomply with reform, and the perception that wealth is asso-ciated with corruption – are unlikely to be addressed under aone-party system.

THE VIETNAMESE GOVERNMENT OFFERS NO VIABLE CHAN-NEL FOR SUSTAINED GROWTH

At present, Vietnam has an “ad hoc” form of govern-ment with limited substantive law. Vietnam’s Constitutionguarantees freedom of speech, freedom of the press, the rightto be informed, the right to associate and assemble, freedomof belief and of religion, presumption of innocence, and pro-tection against discrimination based on gender, ethnicity, orsocial status, etc. However, anything or anyone that “under-mines national solidarity,” as determined by the VietnameseCommunist Party, is not protected by the Constitution. TheParty selectively applies the Constitution by deciding whichjudge(s) will sit on a particular case. The Constitution infact does not limit the Party’s grants of power.

Because Vietnamese citizens have no procedural role inselecting policymakers or organizing government, Vietnam’ssystem of substantive law cannot be fully developed. Atpresent, citizens can only vote according to the Party’s listof approved candidates.24 As a result, the law in the hands ofthe Party is extremely malleable. Other elements that couldprovide a political remedy, such as an independent judiciary,free press, or political opposition, are absent.

Because the allocation of power is in the hands of about150 members of the Central Committee, it stands to reasonthat the only policy discussions that matter are those fromthe Central Committee. This concentration of power alsomeans that no individual member or a minority faction canmobilize a winning majority coalition without beingarbitrarily “expelled” or “silenced” by a majority group inthe Central Committee. In fact, a disproportionate percentageof those who are labeled “dissidents” are former partymembers.25

The problem in Vietnam, as noted by the late general

Such analysis shows thatimprovements in Vietnam’s

economy were not necessarily aresult of greater international

economic integration.


Spring 2003

and dissident Tran Do, is that the Party’s top echelon “hasthe absolute authority and is under the jurisdiction of no laws.The result is none other than a ‘party rule’ in a totalitarianregime.”26 According to Tran, the way out is for the Party’srulers to be subjected to real elections, but not necessarilyinstituting a multiparty system. But why or how would theParty’s top echelon agree to real elections?

Tran Do speaks of how Party’s leaders should “wiseup,” but he is not necessarily optimistic about the role of thegrowing middle class and the growth of “civic” organizations.Perhaps Tran was interestedin emulating Taiwan; withrapid economic growth sincethe early 1970s andsuccessful democratizationin the 1990s, Taiwan hasachieved regimetransformation. This isbecause from the early 1970sthe ruling party put priorityon economic developmentover political stability, andestablished competitiveelections from the local levelto the national level in whichthe elected government waspopularly approved andgained political legitimacy.27

Increases in freedomthat are conducive to growthare unlikely to be recognizedand protected by an “ad hoc”form of government with anincomplete system of substantive law. Because the Vietnam-ese Communist Party is the only body that interprets anddetermines the law in whichever way that benefits itself,greater freedom will not come about. It is unsurprising thenthat Vietnam’s noted improvements in economic life throughincreases in freedom under doi moi were unsustainable.

NOT THE NEXT ASIAN TIGER

Unless the Vietnamese Communist Party limits its grantsof powers and implements a system of procedural law, eco-nomic progress through increases in greater freedom is un-likely to be long-term. Instead, growth is likely to occur in acyclical manner, as dictated by the Party’s need to balancepolitical stability and economic growth.

The Party has currently adopted a strategy to adapt it-self to the global community. This strategy will steadily, butcautiously, make the Party more efficient and less corrupt,and improve the competitiveness of its whole economy andindividual enterprises, according to Prime Minister Phan VanKhai.28 However, anything or anyone that undermines theParty’s authority will be subject to the “strict scrutiny test,”in which any expression that challenges the Party will be“silenced.” This has been demonstrated by the recent surgein the Party’s persecution of religious leaders, scholars, writ-ers, landless farmers and indigenous tribes who have ques-tioned the actions and policies of the Party. Another example

is the Party’s recent decree to step up the fight against anti-governmental materials by requiring both domestic and for-eign agencies, organizations, enterprises and legal entitieswith “foreign elements” in Vietnam to undergo a lengthyand arbitrary approval process for any information postedon websites, newsletters, brochures, press releases, etc.29

Although there is a growing middle-to-upper class, thisclass sees the likely persecution in demanding change;grounded in practical experience, they probably will want toprotect their gains in the current system. While there are the

usual agents and vehicles forsocial and political change,such as an array of religiousand civic groups,intellectuals, and importedideas and values, it is nearlyimpossible to generatechange with a Party thatmonopolizes all power andpervades all dimensions oflife in the country.30

Undoubtedly, such a re-form strategy – because thecurrent growth is fueled bypolicies that do not necessar-ily enhance future growth –impedes sustained eco-nomic growth and develop-ment in contrast to over 100WTO member countries inthe developing world, mostof whom have left Vietnamconsiderably behind.31

However, the Party is not so much concerned with be-ing economically left behind in the region. Instead, it is moreinterested in doing enough to maintain its grip on power (suchas avoiding an increase in the country’s poverty and unem-ployment rates, currently about 35 and 25 percent, respec-tively).32 Interestingly, the Party has discovered that, in go-ing global, the country can grow to an extent like 7 percentannual GDP growth for a period of time without either in-creases in economic freedom or political liberalization.

By becoming more integrated with the global commu-nity through its membership in the ASEAN, a bilateral part-nership with the US, and perhaps WTO membership in thenear future, Vietnam can achieve economic growth throughits “comparative advantage” for a period of time withoutinviting political instability. Some of Vietnam’s “compara-tive advantages” include its literate, industrious and youngpopulation that foreign corporations are attracted to; itsworld-leading exports of coffee, rice, and cashew nuts toforeign markets; and its historical legacy and beautiful physi-cal landscape that have drawn foreign visitors. As for areasin which substantive reforms are required, Vietnam has goneonly so far as to implement “non-essential” transparencyprovisions at a certain level, legislate “impermanent” for-eign investment laws and intellectual property rights, andslash only the weakest state-owned enterprises or turn theminto private enterprises while keeping the same management.

For a period of time, this strategy has paid, and is likely

Internet cafes provide links to the international community.


to continue to pay, dividends. In the first ten months of 2002after the bilateral treaty agreement with the US, Vietnam’sexports to the US grew by 109 percent compared to the firstten months of 2001 – from $863 million to $1.8 billion.33

With its ties to ASEAN nations and other countries (likeFrance, Australia, South Korea, and Japan), Vietnam expectsto earn $2.1 billion from 3.5 million foreign visitors in 2005compared to $1.6 billion from 2.8 million visitors in 2002.34

In addition, with small to medium steps at a cautious pace tomake the Party more efficient and the economy more com-petitive, it is very likely that Vietnam will satisfy its obliga-tions under the Bilateral Trade Agreement with the US, gainWTO membership, and continue itscurrent GDP growth at 7 percent perannum in the coming years.

However, the current strategy isshort-term in nature. Most importantly,when externalities of the currentgrowth affect political stability or whenthe benefits of this strategy are nearly exhausted, the coun-try will likely hit a wall and deflate drastically, as it did inthe late 1990s. This cyclical growth cannot sustain devel-opment, and cannot result in “development as freedom.”Thus, Vietnam is unlikely to become the next Asian Tiger.

For the Party, this cyclical growth is a price worth pay-ing for political stability. As Professor Tran Phuong says,“[e]ach country brings to the process of integration its owndifferent specific conditions.”35 It appears that each countryalso brings its own limitations.

MORE LIKE A GLASS TIGER

On one hand, the Vietnamese Communist Party has nowbrought about higher GDP growth relative to the late 1990s.But on the other hand, the Party has explicitly mapped out astrategy to integrate into the global market without increas-ing economic or political freedom.

In Vietnam’s case, because the current economic growthis not accompanied by increases in economic freedom (thecountry has been categorized as “repressed” since 1995, ac-cording to the Heritage Foundation36) or political freedom(it has been categorized as “not free” for most of the yearssince 1975, according to the Freedom House), there is a priceto be paid. This includes inconsistent and unsustainable eco-nomic growth and development. It also includes child labor,particularly among ethnic minority children and children ofrecent migrants, and a steady increase of the income gapbetween Vietnam’s haves and have-nots, between rural andurban residents and between men and women.37

Analysts like Ronald Inglehart have noted that economicgrowth seems to bring a gradual shift from survival values(such as anything goes to benefits one’s self and family) toself-expression values (such as interpersonal trust, tolerance,and participation in decision-making), which facilitates eco-nomic development.38 Such a shift to self-expression valuesis more likely to be sustained if it is accompanied by in-creases in both economic and political freedom. The currenteconomic growth in Vietnam could cause, and probably hasto some degree already caused, such a shift to self-expres-sion values. However, self-expression values are at present

relatively low in Vietnam, according to The World ValuesSurvey.39 It bears noting that these self-expression valuesmay very well be higher among the Catholic, Protestant andBuddhist populations in the country, since religion in gen-eral stresses individualism and at the same time fosterscommunitarian values, according to cultural experts like MaxWeber and Edward Banfield.40 Such values are unlikely totake root unless they are respected and can be expressed inthe political process. If not, those who possess self-expres-sion values will likely dispossess such values for fear of be-ing “silenced” or will decide to take their values somewhereelse more receptive to them, such as the US, Canada, Aus-

tralia, France, Singapore, and Japan.In Vietnam’s case, the Party ex-

plicitly does not condone any self-ex-pression values that contravene Statepolicies. Not surprisingly, the Party ismost suspicious of the Buddhist,Catholic, and Protestant populations

and has thus regulated their religious activities. This is be-cause these groups look to religion to provide adequate moralsupport for societal needs, and are likely to question a non-religious authority that sees itself as the main factor insociety’s progress. In fact, religious leaders are second onlyto Party members when it comes to having a disproportion-ately high percentage of those who are labeled “dissidents.”41

Lastly, international development organizations such asthe World Bank and the United Nations Development Pro-gram (UNDP) have come to agree that emerging marketsneed to be supplemented with social safety nets, environ-mental improvements, an education system that is linked tothe masses, and recognition of women’s rights. From a cul-tural perspective, the “overarching objective” of develop-ment is to maximize the kind of life local cultures value, and“have reason to value.”42

In Vietnam’s case, as mentioned earlier, the governmentoffers no viable channel for citizens to collectively determine,let alone to live, the kind of life they value. In influencinggovernment policy, the only viable opportunity for citizensto be heard is when the Party’s leaders “knock on every doorand tell people to vote according to the party’s list.”43

Improvising, some citizens “just go down the list, look atthe birth dates and choose the youngest guy.”44 This meansthat citizens cannot make the current economic growth intosomething that is more sustainable and egalitarian, and onethat can truly benefit their way of life. In addition, people’sself-expression is unlikely to take root and solidify the currentgrowth into the long-term. In effect, the rigidities ofVietnam’s political system create a “glass ceiling” foreconomic growth and “development as freedom.”

CONCLUSION: IS THERE A WAY OUT?

“The central liberal truth is that politics can change aculture and save it from itself,” said the late Daniel Moynihan,and “[t]he central conservative truth is that it is culture, notpolitics, that determines the success of a society.”45

In exploring Moynihan’s two truths, many observers,like David Lamb, have come to agree that if the VietnameseCommunist Party “just got out of the way and let its people

For the Party, this cyclicalgrowth is a price worth paying

for political stability.


Spring 2003

exercise their inherent strengths, Vietnam could haveadvanced light years instead of miles in terms of social,political, and economic development.” 46 Simply put,“Vietnam was like a racehorse whose jockey kept yankingon the reins rather than giving the animal its head to find fullstride.”47 Another observer, Henry Kamm, similarly noted:

Far more than any of their neighbors, [theVietnamese] have learned not only to make do withlittle, but even to do very well with a minimum ofeverything except inventiveness... A governmentthat throughout the wars prevailed because it calledon these same qualities of endurance, energy, andresourcefulness, and saw its antagonists fail becausetheir foreign sponsors did not trust in thesequalities... [Likewise, in the past decades,] theCommunist party’s faith in an alien ideology [andits balance between political stability and economicgrowth] rather than in the native gifts of its ownpeople [relatively] held the country down,demoralized its population, and made Vietnam abackwater, while most of the rest of its regionentered the international mainstream.”48

Thus, it seems that only political reform can unleash theVietnamese people’s native talents and allow self-expres-sion values to flourish. This is important because sustainedsocial, political, and economic development lies in its re-spect for people’s inalienable rights and natural gifts.

In the end, it would be very difficult to dismiss a “world-wide empirical trend linking economic modernization andstable democracy.”49 This does not mean that developingcountries have to discard their histories and cultures. It hasbeen said that culture is not destiny. Culture is capable ofevolving. Yet, histories of various countries can lead to varia-tions of democracy. The experiences of Japan, Taiwan, andSouth Korea are illustrative of this variance.

Greater international economic integration is unlikelyto make Vietnam the next Asian Tiger. Rather, what mattersis whether or not the Vietnamese Communist Party will ex-plicitly grant greater economic and political freedom to theVietnamese people.

ENDNOTES

1 Doi moi was “to strengthen and develop the socialisteconomy, first of all, to enable the state sector to really playthe leading role” but also to allow private small-scale com-mercial activity, as proposed by the Sixth National Congressof the Communist Party of Vietnam (1987). See VCP (1987),Sixth National Sixth National Congress of the CommunistParty of Vietnam, (Hanoi: Foreign Languages PublishingHouse), 66.2 The World Bank in collaboration with the Asian Develop-ment Bank Consultative Group Meeting for Vietnam, “Viet-nam Delivering on its Promise,” World Bank Group (De-cember 2002), 1.3 James Riedel and William Turley, “The Politics and Eco-nomics of Transition to an Open Market Economy in Viet-nam,” OECD Development Center, Technical Paper No. 152(September 1999). See http://www.oecd.org/dev/pubication/tp1a.htm.4 Economic freedom, as measured by the Heritage Founda-tion, is based on an index that include variables that fall intocategories of trade policy, fiscal burden of government, gov-ernment intervention in the economy, monetary policy, capitalflows and foreign investment, banking and finance, wagesand prices, property rights, regulation, and black market ac-tivity. See www.heritagefoundation.org. Political freedom,as measured by Freedom House, is based on two indices ofpolitical rights (categories include free elections, minorityrights, political opposition, and right to organize politicalparties) and civil rights (categories include freedom of ex-pression and belief, association and organizational rights,rule of law and human rights, personal autonomy and eco-nomic rights). See www.freedomhouse.org.5 Holcombe Gwartney and R. Lawson, “Economic Freedomand the Environment for Economic Growth,” Journal of In-stitutional and Theoretical Economics, Vol. 155, No. 4(1999), 656-658.6 Economic freedom, as measured by the Economic Free-dom of the World Report, is based on an index that includevariables that fall into the categories of size of government,legal structure and security of property rights, access to soundmoney, freedom to exchange with foreigners, and marketregulations. See www.freetheworld.com.7 Tatsumi Okabe, “China’s Prospects for Change,” in LarryDiamond and Marc Plattner (eds.), Democracy in East Asia(Baltimore and London: The Johns Hopkins University Press,1998), 181.8 Gerald Curtis, “A ‘Recipe’ for Democratic Development,”in Larry Diamond and Marc Plattner (eds.) (1998), ibid, 222.9 This is not to say that democratization has not broughtabout political problems, such as the lack of strong politicalinstitutions and civic organizations. See: Byung-Kook Kim,“Korea’s Crisis of Success,” and Yun-han Chu, “Taiwan’sUnique Challenges” in Larry Diamond and Marc Plattner(eds.) (1998), ibid, 113-132 and 133-146, respectively.10 This is not to deny that some political changes are takingplace, as a result of economic integration. These changeshave brought about what Vietnam scholars Frederick Brownand Carl Thayer have referred to as “authoritarian pluralism.”11 The World Bank in collaboration with the Asian Devel-


opment Bank Consultative Group Meeting for Vietnam,“Vietnam Delivering on its Promise,” World Bank Group(December 2002). See http://www.worldbank.org.vn/data_pub/reports/VDR03/VDR03.htm.12 See Vietnamese Ministry of Foreign Affairs atwww.mofa.gov.vn, or Nhan Dan, the Vietnamese Commu-nist Party’s mouthpiece, at www.nhandan.org.vn.13 Barry Coulthurst, “Vietnam: Economic Reform is Gradu-ally Gaining Momentum,” Invest Avenue (February 2002),http://www.investavenue.com/article.html?ID=3918.14 Defined by Peter Bearse and Roger Uaughan. See http://www.osec.doc.gov/eda/html/2a1_whatised.htm.15 See The Economist, “Goodnight, Vietnam,” January 6,2000. See www.economist.com/displayStory.cfm?story_id=327942.16 This speech by US Ambassador Raymond Burghardt wasdelivered at The Asia Society, Washington, D.C. chapter onJanuary 21, 2003.17 Defined by Peter Bearse and Roger Uaughan. See http://www.osec.doc.gov/eda/html/2a1_whatised.htm.18 David Lamb, Vietnam Now (New York: Public Affairs,2002), 111.19 The Economist, “Goodnight, Vietnam,” January 6, 2000.20 Barry Coulthurst, “Vietnam: Economic Reform is Gradu-ally Gaining Momentum,” Invest Avenue (February 2002).21 Vietnam Economic Times, “Should Create Attractive Forcefor Foreign Enterprises,” (Jan. 26, 2003). http://www.vneconomy.com.vn/en_index.php?action=preview&cat=13&id=021104144627.22 Mancur Olson, Power and Prosperity: Outgrowing Com-munist and Capitalist Dictatorships (New York: Basic Books,2000), 185.23 Ibid, 27.24 Zachary Abuza, Renovating Politics in Contemporary Viet-nam (Boulder, CO, and London: Lynne Rienner Publishers,2001), 89-95.25 Ibid, 23-29.26 Tran Do, “The State of the Nation and the Role of theCommunist Party,” http://www.fva.org/documents/dissident/trando.htm.27 Samuel Ku, “The Political Economy of Regime Transfor-mation: Taiwan and Southeast Asia,” World Affairs, Vol. 165,No. 2 (2002), 74-75.28 Vietnam News, “Government promises greater economicreform,” (Feb. 2, 2003). http://vietnamnews.vnagency.com.vn/2003-02/06/Stories/01.htm.29 Vietnam Economic Times, “Websites and the Internet,”(Jan. 26, 2003). http://www.vneconomy.com.vnen_index.php?cat=16&action=preview&id=030123144952.30 Andrew Pierre, “Vietnam’s Contradictions,” Foreign Af-fairs, Vol. 79, No. 6 (November-December 2000), 73.31 Vietnam Economic Times, “Going Global,” (Jan. 26, 2003).http://www.vneconomy.com.vn/en_index.php?action=pre-view&cat=02&id=030123141558.32 See www.worldbank.org.vn.33 Vietnam Economic Times, “No pain no gain,” (Jan. 26,2003). http://www.vneconomy.com.vn/en_index.php?act-ion=preview&cat=02&id=030123142019.

34 Vietnam Economic Times, “Tourism Sector to Rely onOverseas Marketing to Rake in More Visitors,” (Jan. 26,2003). http://www.vneconomy.com.vn/en_index.php?action=preview&cat=13&id=030123094747.35 Vietnam Economic Times, “No Pain No Gain,” (Jan. 26,2003).36 See www.heritagefoundation.org.37 See the World Bank’s Reports and Publications at http://www.worldbank.org.vn.38 Ronald Inglehart, “Culture and Democracy,” in LawrenceHarrison and Samuel Huntington (eds.), Culture Matters(New York: Basic Books, 2000).39 See http://www.democ.uci.edu/democ/archive/vietnam.htm.40 See Max Weber, The Religion of China (New York:Macmillan, 1951); see also Edward Banfield, Moral Basisof a Backward Society (Chicago: Free Press, 1958).41 See Zachary Abuza (2001), ibid, 23-29.42 Amartya Sen, Development as Freedom (New York: Ran-dom House, 1999), 16-18.43 Free Vietnam Alliance, “Interview with Hoang MinhChinh,” Vietnam Democracy (July 1996).44 John Chalmers, “Vietnam Gears Up for Low-Key Elec-tions,” Reuters, July 13, 1997.45 Samuel Huntington, “Cultures Count,” in LawrenceHarrison and Samuel Huntington (eds.) (2000), ibid, xiv.46 David Lamb (2002), ibid, 126.47 Ibid, 126.48 Henry Kamm, Dragon Ascending: Vietnam and the Viet-namese (New York: Arcade Publishing, 1996), 287-288.49 Francis Fukuyama, “The Illusion of ‘Asian Excep-tionalism’,” in Larry Diamond and Marc Plattner (eds.)(1998), ibid, 225.


Spring 2003


Dr. Vinay Bharat-Ram, one of India’s leading industrialists, re-cently stated that although the economy drives the political agendain the United States, the opposite is true for emerging economies

such as India. Instead, in India politics drives the economy.1 As India’scurrent coalitional government led by the Bharatiya Janata Party (BJP)comes to the close of its five-year term, India’s prospects for economicliberalization can be analyzed through a political lens.

At a time when elections for nine state governments are scheduledfor 2003,2 followed by a national election in 2004, politics has alreadybegun to cast a shadow on the BJP government’s agenda for economicreforms. The compulsions of the election cycle dictate the need to satisfyvarious interest groups that support the BJP-led government. The reformagenda is often the casualty, especially if it is perceived to harm theseinterest groups and adversely affect the electoral fortunes of the rulingparty.

This article focuses on the fate of two important reforms that exem-plify the dynamics of politics driving economics in India today. The firstof these concerns the failed efforts to implement tax reforms scripted bythe economic advisor to the Union finance minister, Dr. Vijay Kelkar, inthe Union budget for 2003-04.3 Second is the BJP government’s falteringprivatization agenda, which again illustrates how powerful interest groups– both within and outside the government – have succeeded in stallingimportant reforms.

Regarding tax reforms, BJP politicians worried about the impact onthe party’s primary support base, the urban middle class. Kelkar’s pro-posals called for the removal of tax exemptions for salary earners to buildhouses and invest in small savings schemes. In addition, tax reforms wereproposed to tap the agricultural sector, which raised concerns among BJP’sallies in the coalition government who represent agrarian interests. Oneof them is Ajit Singh, the Union agricultural minister, whose supportbase is the prosperous farming belt in the western region of the state ofUttar Pradesh. Clearly pandering to his supporters, he stated that this wasthe “most impractical and ill-thought out proposal.” According to Singh,farming was not remunerative enough to be taxed, especially after themonsoon rains last year.4

Politics is also dictating the fate of privatization. Prior to 1991, so-cialist-inspired economic development in India meant that vast swathesof industries were under government control. After 1991, however, therewas a paradigm shift, which opened the economy to market forces and tothe influence of the private sector as an engine of growth. This processentailed the gradual withdrawal of the government from the command-ing heights of the economy. Efforts were begun to privatize state-ownedpublic sector undertakings (PSUs), a legacy of government-sponsoredindustrialization since the 1950s.

Privatization is now most likely to be slow as the process enters acontested political terrain. A case in point involves two oil sector PSUmajors, Hindustan Petroleum Corporation Limited (HPCL) and BharatPetroleum Corporation Ltd. (BPCL), whose privatization plans face stiffopposition from interest groups. For example, unions vociferously op-pose these sell-offs fearing widespread job losses. This type of politicalpressure signaled the end of a push for strategic sales of the PSUs, evi-dent in a hiatus regarding HPCL and BPCL. The fate of these two com-

POLITICS OF ECONOMIC LIBERALIZATIONIN INDIABY N. CHANDRA MOHAN

N. Chandra Mohan (Ph.D. in Economics, Jawahar-lal Nehru University) is Consulting Editor at TheFinancial Express and ex-Business Editor at TheTimes of India (1997-2000). Author of articles onIndian economic development published in editedvolumes, Mohan has also presented papers at aca-demic conferences in India and the United States.


Spring 2003

panies exemplifies the challenges of big-ticket privatization.Prime Minister Atal Behari Vajpayee himself indicated

in an informal lunch with journalists that reforms which hurtthe electoral prospects of the BJP will not be implemented:“Well, if political effects are there, we will not reform. We’llnot reform if there [is] a political cost to pay.”5 This providesan indication of the mood at the highest levels of the BJP-led government, indicating that politics will lead the wayin determining the reformagenda of the BJP-led coali-tion government.

ONE STEP FORWARD, TWO

STEPS BACK

What were the origins ofthis “one step forward, twosteps back” reform phenom-enon? The defining momentcame in April 2002, when theruling party faced electoralreverses in the state assem-bly elections in Punjab, UttarPradesh and Uttaranchal, aswell as municipal elections inDelhi.

The BJP was crestfallenafter its electoral defeats.Uttar Pradesh is significantbecause it represents theHindi-speaking heartlandwith the highest Parliamen-tary constituencies. Delhi isthe BJP’s traditional bastionof support, especially amongpeople uprooted by the Par-tition of India in 1947 whostreamed in from Pakistan.Losing in the municipal elec-tions provided a clear signthat the ruling party was be-coming steadily alienatedfrom its traditional supportbase.

These electoral defeatsprovided the impetus for the BJP to reexamine its economicreform policies through an electoral lens. After witnessingelectoral setbacks and the BJP’s response to them, socialscientists may have had a sense of deja vu.

Going back in time, a similar fate clouded former PrimeMinister Rajiv Gandhi’s half-hearted efforts to liberalize theeconomy after losing the Haryana elections in 1987.6 Rajivhad an overwhelming electoral mandate that swept him topower, but his halting and modest efforts at reform wereimpeded by resistance from powerful vested interests. Rajivsought to liberalize imports of capital goods and machineryto improve the efficiency of Indian industry, but this wasresisted by domestic manufacturers and organized labor, forc-ing Rajiv to retreat.

Economic reforms initiated by former Prime Minister

Narasimha Rao also suffered after the Congress Party lostimportant assembly elections in Andhra Pradesh andKarnataka in 1994. Rao’s technocratic reforms had beendriven by an IMF stabilization package, which recommendedmassive spending cuts by the government, besides a devalu-ation of the Indian rupee among other measures. The imme-diate crisis was an external one involving the building up offoreign exchange reserves through faster export growth. After

1994, Narasimha Rao tookthe middle path by driftingaway from his earlier techno-cratic reforms.

Electoral setbacksweakened Rao’s effective-ness in implementing eco-nomic policy, although onemight argue that communal-ism was more to blame thaneconomics. The early 1990swas a formative time forHindu fundamentalism atAyodhya, and communal car-nage along with the dramaticMumbai bomb-blasts di-verted the government’s at-tention away from economicissues. Moreover, Rao facedinternal challenges to hisleadership. Despite all this,electoral setbacks were per-ceived as a repudiation of re-forms. While Rao remainedpublicly committed to re-form, he could no longer pro-vide political support to theprocess in practice.

These episodes under-score the electoral politics ofliberalization. Party leader-ship both then and nowblamed economic reformagendas for alienating theirsupporters during the elec-tions. At the BJP nationalexecutive committee meeting

held shortly after the electoral upsets in April 2002, leadersheld the Union budget responsible for the alienation of middleclass voters. The party’s mood has remained anti-reform sincethat time. Like in 1987 and 1994, the ruling party’s stanceon reform is best described as “one step forward, two stepsback.” Bearing in mind this characterization, this article dis-cusses below the two reform initiatives, Kelkar’s tax pro-posals and the BJP’s privatization efforts.

MOMENTARY AU TONOMY

Why have economic reforms become politically prob-lematic? I discuss this question elsewhere in a paper co-authored with Professor Ronald Herring entitled, “EconomicCrisis, Momentary Autonomy and Policy Reform.”7 One

Farmers are becoming participants in, as well as clients of, thegovernment.


reason is clear: in a democracy, state autonomy is alwaysdifficult to come by.

Perhaps the most striking period in which the BJP-ledgovernment enjoyed momentary autonomy to push throughreforms occurred after the Pokhran nuclear blasts and theimposition of sanctions in 1998. But the government’s ef-forts in this direction, like opening up the insurance sector,faced intense opposition, including within the party itself. Itis paradoxical indeed that when the BJP was most keen toreform, its efforts attracted tremendous opposition from itsgrassroots supporters and its trade union wing.

Given conflicting pressures, external sector reform – likelowering tariffs, facilitating convertibility, and encouragingforeign direct investment – has madeconsiderable progress, while the domes-tic agenda remains subject to problemsof implementation and intra-party op-position. On the question of labor re-form, hire-and-fire policies are highlycontentious, and the ruling party’s owntrade union wing has taken to the streetsprotesting the move.8 The fate of theprivatization and the Kelkar tax proposal further illustratesthis problem, and these issues will be discussed below.

Did the BJP gain a momentary autonomy in December2002 with its decisive triumph in the state elections inGujarat? To a large extent, this victory was the result of po-larizing the electorate on the divisive issue of religion. Thesignificance of the Gujarat election for the BJP’s campaignstrategy cannot be overemphasized. The election followedan outbreak of statewide violence by the majority Hindupopulation against the minority Muslim community after agroup of Muslims was held responsible for burning a traincompartment full of Hindus on the Sabarmati Express onFebruary 27, 2002. In this context of highly charged com-munal sentiments among voters, the BJP swept the elections.At the time, party leaders speculated that a similar polariza-tion in other states would pay similar electoral dividends.

The top leadership believes that its fundamentalistagenda must be kept alive in order to win various state elec-tions this year and the national elections in 2004.9 Not sur-prisingly, fundamentalist issues, rather than economic ones,increasingly dominate the BJP’s agenda. The building of aRam temple at Ayodhya (on the site where the BJP’s sup-porters razed a Muslim mosque in 1992) continues to be astrategy for maintaining the support of the Vishwa HinduParishad and other Hindu groups. Another example of thisfundamentalist agenda is the current discussion in the na-tional legislature concerning the slaughter of cows. With somany popular fundamentalist issues on the agenda, little roomexists for less-provocative but more pressing reform issues.

Circumstances have shown that the BJP’s autonomy afterGujarat was indeed momentary, if it occurred at all. The BJP’sstrategy for replicating the Gujarat model of polarizationreceived a setback in Himachal Pradesh in February 2003.The BJP lost the election despite a high-profile campaign inwhich Prime Minister Vajpayee along with the chief minis-ter of Gujarat, Narendra Modi, appeared on behalf of its can-didates. When the news of defeat arrived, the BJP leader-ship blamed in-fighting within the state’s party unit rather

than its polarizing strategy.

A SCAPEGOAT AND A SCION

After initial electoral setbacks in April 2002, the BJP’snational executive committee found a scapegoat in the Unionbudget presented by the then-finance minister YashwantSinha. Policies intended to improve India’s fiscal situationwere believed to have alienated the middle class, which servesas an important political base for the BJP. The adverse im-pact of a lower interest rate regime on retired persons andthe pruning of tax rebates on contractual savings were par-ticularly blamed. A series of financial scams compounded

the problem and engulfed mutual fundinstitutions like the Unit Trust of India.

The BJP leaders believed thatYashwant Sinha’s budget cost them theelections, and he was thus replaced byJaswant Singh, the scion of a royal fam-ily in Rajasthan. Clearly indicating thathe planned to improve the electoral for-tunes of the ruling party, Singh pointed

out that “food should reach the stomachs of the poor” andthat there should be more money in the pockets of citizensand the purses of housewives in the country.10 These welfaristobjectives were reiterated in his recent Union budget for2003-04.

Although the middle class represents an important elec-torate in urban India, no elections can be won without ad-dressing the needs of the rural poor. Indeed, Singh’s firstbudgetary announcement was a scheme to provide heavilysubsidized food grains to an additional five million familiesliving in poverty in villages. Rajasthan and Madhya Pradeshexperienced severe drought conditions last year, and reportssurfaced of starvation and hunger-related deaths in these lo-cations even though the government had ample stocks offood grains. Because elections are due to be held in thesestates later this year, followed by a national election, thegovernment is keen to ensure that deprivation-related issueswill not damage its electoral prospects.

Clearly, politics drives the economics of Singh’s bud-get. In simple terms, his mandate is to see the party throughto the five state elections remaining this year and the na-tional elections in 2004. Under these circumstances, he willonly do the bidding of the Prime Minister. If the latter isaverse to implementing politically difficult reforms, so toois Singh. In fact, what he unveiled in his maiden budget for2003-04 is a populist proposal whose thrust is largely pro-middle class in orientation, a move encouraged by PrimeMinister Vajpayee.

In contrast to previous budgets, the one proposed bySingh assures the middle class that its interests are foremoston his party’s agenda. The budget reduces excise duties on awide range of industrial goods to boost their demand, andthe middle class is expected to benefit from cheaper cars,air-conditioners, bicycles, and imported liquor. In the newbudget, Singh also provides tax rebates for the education ofchildren along with pension schemes for the retired.

The finance minister’s budgetary strategy imparts a feel-good factor to the middle class and provides incentives for it

Fundamentalist issues, ratherthan economic ones,

increasingly dominate theBJP’s agenda.


Spring 2003

to spend more. In terms of savings, Singh’s measures aredesigned to divert the middle class away from contractualsavings to equity investments in the stock market. Accord-ingly, he exempts dividends and mutual funds having eq-uity-oriented schemes from taxation, and capital gains taxhas also been abolished.11

With these electoral compulsions, the impetus to rein inthe combined fiscal deficit of the central and state govern-ments, which constitutes approximately 10 percent of thegross domestic product (GDP) and is crowding out resourcesfor private investment, has petered out.This is especially unfortunate becausethe government’s borrowing require-ments are enormous. Expenditures oninterest payments, defense, subsidies,and salaries of its employees consis-tently outpace the government’s tax rev-enues. Interest payments alone accountfor 50 percent of the total governmentrevenues.

Given his efforts to woo the middle class, Singh is con-strained from pruning subsidies and wasteful expenditure.His effort to modestly trim fertilizer subsidies provoked anoutcry from the BJP’s allies, which had less to do with themerits of the policy and more with pandering to the party’selectoral base. Meanwhile, there were strong protests in theParliament with the Congress Party demanding a rollback.The opposition’s question is: why is Singh asking the farm-ers to pay more for fertilizers, when he has made availablecheaper cars and other items of middle class consumption?Though Singh initially argued that the matter was non-ne-gotiable, political pressure has forced him to back down onthis budgetary move.

An alternative means to rectify the fiscal situation wouldbe to raise revenues by broadening the tax base, but this isalso problematic for political reasons. The agricultural sec-tor which accounts for 25 percent of India’s GDP contrib-utes next to nothing by way of revenues, because of the wide-spread opposition to any effort to tax it. Services representthe most important sector in the economy, accounting for 50percent of the GDP, but contribute not more than 0.2 percentof the GDP in direct taxes. The fiscal situation cannot be setin order when sectors accounting for 75 percent of thenation’s GDP provide negligible direct tax revenues.

The imperatives of politics cast a long shadow overSingh’s maiden budget, which is replete with populist give-aways and welfarism. Singh’s objective is to ensure that foodgrains reach the needy and the middle class has more tospend.12 With a packed election schedule this year and in thenext, the BJP simply cannot take the risk of alienating itstraditional bastions of support. Nowhere have these com-pulsions been more evident than in the dilution of Kelkar’stax proposals.

KELKAR TASKFORCE ON TAXES

The far-reaching proposals of the Kelkar taskforcesought to simplify the existing tax structure and addresslongstanding oversights within it in order to mobilize addi-tional tax revenues. Agriculture had never been sufficiently

taxed due to state governments’ dependence on wealthy farm-ers for political support. Services likewise remained a largelyuntapped source, because the sector had not been signifi-cant enough to warrant attention when India became inde-pendent. The two most controversial aspects of the recom-mendations that emerged from the Kelkar taskforce involvedthe taxation of agriculture and the removal of all middle classtax exemptions.

Kelkar’s proposal advocated a system of tax rates ac-cording to income bracket.13 This system exempted those

with annual incomes up to Rs 100,000,which (at the rate of Rs 50 to a US dol-lar) is equivalent to approximately$2,000 and reflects a lower middle classstandard of living in India. However,according to the proposal, those earn-ing between Rs 100,000 and Rs 400,000would pay taxes at a rate of 20 percentand those with Rs 400,000 plus incomes

would pay 30 percent. In conjunction with simplified taxrates, the proposal entailed the removal of all exemptions,including tax breaks on housing and savings.

When these proposals were submitted to the govern-ment, they triggered a storm of protest from the BJP itself.With more state elections this year and national elections inthe next, the party feared that Kelkar’s proposals would con-stitute a political minefield among middle class voters. Af-ter the election losses in April 2002, the BJP was in no moodto take chances by implementing Kelkar’s report during therest of its five-year term.

The budget of Finance Minister Jaswant Singh discardedmany of Kelkar’s proposals that negatively impacted themiddle class. In particular, Singh rejected the proposal toscrap all exemptions and retained most tax breaks, includ-ing those on housing and savings by senior citizens. Singh’sbudget is also silent on the most radical proposal, namely, totax agricultural income. Given the intense opposition fromthe BJP allies, this idea has also been abandoned.

Politics thus has sealed the fate of Kelkar’s proposalson direct taxes. The government has cherry-picked only thosesuggestions which are uncontroversial, such as the simplifi-cation of the tax regime through the establishment of a fullycomputerized Tax Information Network. Given the need tosatisfy its support base ahead of the elections, a valuablereform prospect has been wasted.

STALLED DRIVE TO PRIVATIZE PSUS

Privatization of PSUs is another area in which politicalimperatives continue to bedevil a reform that potentiallycould have been the biggest achievement of the BJP-ledgovernment. As liberalization gained momentum in the early1990s, successive governments offloaded small quantitiesof government-held shares in PSUs to bridge fiscal deficits.This action was termed disinvestment and was largelyuncontroversial in nature, as control still remained very muchin the hands of the government.

The BJP government, however, went much further andboldly embarked on privatization through strategic sales ofthe government’s stake in selected PSUs. In sharp contrast

The opposition asks: why isSingh asking the farmers to

pay more for fertilizers, whenhe has made items of middleclass consumption cheaper?


to the earlier sell-offs, strategic sales entail a transfer of man-agement control. Not surprisingly, they attracted politicallightning as no other reform did – especially from the Con-gress Party and the Left, which considered them to be com-parable to selling the family silver and a reversal of the post-Independence strategy of state-sponsored industrialization.

Total central government holdings in PSUs have beenpegged at Rs 785 billion, and the strategic sales since 1999have offloaded only 1 percent of that total. Although theamount realized was only Rs 113 billion or 37 percent of therevenues raised through sell-offs since1991,14 the exercise has neverthelessground to a halt. Due to vested interestsgetting in the way, only a diluted agendacan now be expected during the remain-ing term of the BJP-led government. Tobe sure, there will be some sale of mi-nor PSUs, but the drive for big-ticketstrategic sales has clearly stalled.

The credit for this bold reform,which awakened the moribund bourses, should be accordedto the dynamic Arun Shourie.15 The former crusading jour-nalist turned technocrat-politician did what few others daredto do – he sold the government’s stake in the country’s pas-senger car giant Maruti Udyog Ltd. and the long-distancetelecommunications monopoly, Videsh Sanchar Nigam Ltd.,among numerous other PSUs. These were all sales in whichmanagement control passed on to the private buyer.

As noted earlier, the sale of the government’s stake inHindustan Petroleum Corporation Ltd. (HPCL) and BharatPetroleum Corporation Ltd. (BPCL) reached a perpetualgridlock on September 7, 2002, when the government de-cided to defer any decision over their privatization. Sincethat time, complications remain despite the meetings of theCabinet Committee on Disinvestment (CCD), which is theofficial body empowered to take decisions on this matter.The privatization of HPCL has finally been approved, butmatters will likely be delayed considerably due to the politi-cal interests at stake.

The Union cabinet still remains deeply divided over themove, especially when electoral considerations loom large.Both the finance minister Jaswant Singh and the defenseminister George Fernandes remain hostile to Reliance In-dustries, India’s largest private sector company bidding forHPCL or BPCL. Their argument is that a public monopolyshould not become a private monopoly.

Interestingly, even the Swadeshi Jagran Manch (SJM)supports this position. However, the SJM cannot really keepReliance out of the bidding process.16 Even if that could bedone, given the organization’s antipathy for multinationalcorporations, it is unlikely that Royal Dutch Shell would bean appropriate substitute. At the other end of the spectrumare cabinet members, such as Petroleum Minister Ram Naik,who are loath to lose administrative control of PSUs. Theyoppose strategic sales, as these erode rent-seeking possibili-ties and patronage-client relationships with PSUs. This atti-tude is also seen in the Union civil aviation ministry, whichhas stalled the sale of the national flagship carriers, Air In-dia and Indian Airlines.

The bureaucracy is a big source of opposition but at-

tracts less attention. Approximately 90 percent of state-levelPSUs are headed by civil servants belonging to the IndianAdministrative Service, who are unenthusiastic about hand-ing over control. State governments, too, are opposed to sell-ing off profitable PSUs in their region, and this oppositionwill only intensify when elections loom on the horizon. Thelast but not the least important factor is organized labor. Thetrade unions are the biggest and most vocal sources of oppo-sition to privatization, because they fear the loss of jobs.

None of these vested interests has so far relented on thisissue, with the exception that the Unioncabinet cleared the privatization ofHPCL on January 26, 2003. With poli-tics hijacking the BJP’s privatizationagenda, doubts have surfaced over thetime frame for the sale of HPCL andover the issue of whether or not publicsector oil PSUs such as the Oil andNatural Gas Corporation and GAIL canparticipate. Arun Shourie does not fa-

vor their participation, but Ram Naik evidently does. TheUnion cabinet will thus have to deliberate on this issue on acase-by-case basis, factoring in political consequences asstate and national elections draw nearer.

With two more years left in its term, the BJP-led gov-ernment is under pressure to be politically pragmatic ratherthan reformist. Rather than promoting policies that mightinflict short-term austerity yet garner long-term benefits, thegovernment has adopted this “one step forward, two stepsback” stance on liberalization, which panders to traditionalsupport bases like the urban middle class through welfarism.Singh’s maiden budget clearly reflects these electoral im-peratives.

Despite the setback in the Himachal Pradesh elections,fundamentalist issues continue to dominate the BJP’s agendafor the remaining state elections this year and the nationalelections in 2004. Economic reform is bound to be a casu-alty of this strategy. The BJP is finally learning what RajivGandhi did in 1987 and Narasimha Rao after 1994 with re-gard to the electoral compulsions of liberalization. A reformagenda remains in the shadow of politics.

ENDNOTES

1 “Interdependence of Macro and Micro Economics in theGlobal Environment,” Public Lecture No. 1, Centre for PolicyResearch, New Delhi, November 11, 2002.2 These states are Himachal Pradesh, Meghalaya, Mizoram,Nagaland, Tripura, Delhi, Chattisgarh, Madhya Pradesh andRajasthan.3 India is a federal polity comprised of various states. Unionrefers to the central government.4 The Hindu, December 29, 2002.5 This lunch with editors on the occasion of National PressDay took place on November 16, 2002, and this quote was

Due to vested interests, only adiluted agenda of

privatization can now beexpected during the remaining

term of the BJP-ledgovernment.


Spring 2003

in response to a question posed by Ms. Aditi Phadnis, senioreditor of The Business Standard .6 See Atul Kohli, “Politics of Economic Liberalization inIndia,” World Development 17(3), 1989.7 Amita Shastri and Jeyaratnam Wilson (eds.), Post-Colo-nial States of South Asia (Curzon Press, 2001).8 Hire-and-fire policies did not exist prior to privatizationthanks to the socialist ethos, but that will no doubt changewhen PSUs are turned over to private owners.9 Four of these nine state elections have already been held inthe states of Himachal Pradesh, Manipur, Meghalaya andNagaland at the end of February 2003.10 The Hindu, July 4, 2002.11 These are from budget documents available on the offi-cial website (www.finmin.nic.in).12 Singh was candid enough to admit in the following wayin response to a question as to whether politics or economicsdictated his budget: “There is no year in India that is entirelyfree of elections. Can the job of a finance minister be solelydictated by economics? Is that possible? No, never. The fi-nance minister has to arrive at a synthesis of the competingdemands of politics and economics.” India Today, March10, 2003.13 Towards this end, the taskforce adopted a variant of anidea proposed in the 1960s by the late eminent jurist NaniPalkhivala that pertained to giving a flat income of Rs100,000 to parliamentarians or politicians. This was to befollowed by removing all exemptions and perquisites thatthey enjoyed. This reform was designed to give parliamen-tarians and politicians a sense of the hardships in payingtaxes at the highest marginal rates prevalent in that socialis-tic era.14 Privatization overview, www.divest.nic.in, which is theofficial website of the Ministry for Disinvestment.15 Arun Shourie – the Union Minister for Disinvestment,Information Technology and Communications – is at the helmof this privatization effort but faces intense opposition fromvested interests in government, including trade unions.16 The SJM is a member of a family of political organiza-tions that support the BJP. It generally adopts a highly na-tionalistic stance on economic policies and favors keepingout foreign multinationals.


IN SEARCH OF “GLOBAL STANDARDS”:THE FALLACY OF KOREA’S CORPORATEPOLICYBY SUNG-HEE JWA

Author of numerous books and articles on Korea’seconomy, especially on issues of development,institutional economics and corporate gover-nance, Sung-Hee Jwa is the President of KoreaEconomic Research Institute (Seoul). Jwa’s recentpublications include: The Evolution of Large Cor-porations in Korea: A New-Institutional Econom-ics Perspective of the Chaebol (London: EdwardElgars, 2002); and A New Paradigm for Korea’sEconomic Development: From Government Con-trol to Market Economy (London: Palgrave, 2000).He holds a Ph.D. from the University of California,Los Angeles, and a M.A. and a B.A. from SeoulNational University.

South Korea’s economic management since the early 1960s to atleast 1997 has generally been considered a huge success, and tomany observers, state intervention has been credited with Korea’s

‘miracle’ economy that, amongst other achievements, maintained an av-erage real growth rate of about 8% per annum for nearly four decades. Itis important, however, to realize that state intervention in Korea has byno means been homogeneous. The export-driven “contests” of the 1960sand 1970s that offered access to low-cost credit and subsidies to firmsreaching export targets, for example, contrast sharply with the egalitarianand pro-democratic economic policies of the latter 1980s and 1990s thatattempted to reduce concentration of economic wealth by regulating thegrowth and expansion of large corporations. What is interesting to note isthat much of the economic reform in line with the country’s democratictransformation since 1987 has not resulted in improved economic perfor-mance.1 For example, Korea’s average total factor productivity (TFP)growth rate for 1988-1997 was significantly lower at 3.41% compared to6.64% for the earlier 1964-1979 period.2 Comparing the same two peri-ods again, growth rates of investment in plant and equipment fell from24.7% for the 1964-1979 period to 9.7% for 1988-1997. One might won-der why economic reforms throughout most of the 1980s and 1990s, com-pared to the earlier two decades of Korea’s industrialization, have nottranslated into improved competitiveness, increased investment rates andbetter overall economic performance.3 Is there something that has beenoverlooked in considering the economic policy formulation during thepast two decades? Perhaps, certain features of Korea’s policy, which wereresponsible for exposing Korea’s economy to the contagion of the 1997Asian financial crisis, are not yet fully understood. Many questions re-main in explaining the lackluster economic performance of the post-1987era, when reforms towards a market economy and democracy were in-deed expected to bring about yet another era of unprecedented success.

As a reaction to the 1997 economic crisis and with the widespreadacceptance of globalization by the general public, the concept and goalof “global standards” came to occupy center stage in Korea’s policy for-mulation to improve the country’s competitiveness. It may be argued thatKorea had little choice but to accept prevailing “proven” standards, andthat using benchmarks recommended by the international financial com-munity would expedite recovery that would otherwise be slow in com-ing. The issue here is that, though setting standards (whether “local” or“global”) is indispensable for various economic activities, the Koreangovernment has been misguided in thinking that using the governmentmachinery to uniformly impose rigid and arbitrary standards on the na-tional or sectoral population is what is needed to drive Korea’s reformprocess in the post-crisis era. Specifically, to enforce “global standards,”the government has used (and continues to use) uniform rules and regu-lations in a heavy-handed top-down manner hardly distinguishable fromthe methods used by past authoritarian governments, something which, Iargue here, is unhealthy for the Korean economy not only because it goesagainst the government’s commitment to liberalization but also becauseit vitiates the market mechanism. In fact, uniform regulation may alsohave been a major factor behind Korea’s economic slowdown prior to


Spring 2003

the outbreak of the crisis, and the continued reliance on uni-form regulation, this time under the “global standards” ban-ner, has the potential to become a serious burden on Korea’stransition to a market economy. In this essay, I carefully ex-amine the concept of “global standards” and then argue thatthe government’s imposition of ‘global standards’ throughuniform rules and regulation has been misguided.

“GLOBAL STANDARDS”: WHY ALL THE FUSS?

Discussions about “global standards” seem to have flour-ished with the communication and in-formation age, which also coincideswith the era of globalization. Althoughthere are many commentaries that pointout certain aspects of what might con-stitute “global standards,” a comprehen-sive definition of the term is largely ab-sent from academic and public policyliterature.4 Users of the term “global standards” may begrouped into two broad categories: 1) professionals in engi-neering, medicine, and management science who define ‘glo-bal standards’ as industrial standards designed to increasecompatibility and safety or to reduce operational risk, andso on; and 2) practitioners of public policy and administra-tion, as well as those engaged in journalism and other pur-suits, who can be found arguing over ‘global standards’ interms that lack clarity and precision.

Referring to the first category of usage, where the term“global standards” seems to have gained a good degree ofrespectability because it is often backed by scientific meth-ods, it might be useful to qualify the “global” in “global stan-dards.” A standard that has gained global or universal ac-ceptance in a technical area – for example, some medianlevel of basic education, or minimum best safety practiceswhen dealing with AIDS patients, and so on – may legiti-mately be called a “global standard.” There are yet otherexamples. In the global information technology industry,conforming to the industry’s “global standards” in cable de-sign, networking components and data storage types facili-tates communication linkages so as to shorten connectiontime and increase networking capacity. In terms of manage-ment practices, a huge multinational company may preparea detailed manual that describes procedures and standardsof the corporation’s operations to serve as a reference for itsbranches located around the world. Such ‘standards,’ irre-spective of whether we attach the term “global” or not, Ihave little quarrel with.

The problem begins when we move from the usuallynarrow and technical aspects, specific to certain industriesor lines of businesses, to the second category of usage thataddresses broader issues of public policy, rules and regula-tions. In this sphere, which is often clouded by controver-sies and myths, a clear conceptualization of “global stan-dards” has remained elusive. The spectrum of opinions thatexists over “global standards” illustrates how complex theissue really is; this contrasts rather sharply with the ease withwhich streams of recommendations are made by internationalfinancial organizations such as the World Bank, the Interna-tional Monetary Fund (IMF), and the Organization for Eco-

nomic Co-operation and Development (OECD).5 The situa-tion becomes more worrisome as the general public becomesless and less critical, while governments become more andmore arrogant under the safety of “proven” practices. Forexample, it is all too common to find casual comments inlocal and international newspapers, such as: “Korean com-panies must hasten to build a managerial infrastructure thatis compatible with global standards,” or “the Korean way ofdoing business is far different from, and falls far short of,global standards,” and so on. The term is used casually inacademic circles as well as among the public and often with

the unwarranted confidence and assur-ance that everyone knows what itmeans. Nothing is more guaranteed toimpose conformity and to stultify in-telligent and informed debate than toelevate such a muddled term to the cen-ter of economic policymaking. Thereis, therefore, a strong need to seriously

rethink the concept of ‘global standards.’ International fi-nancial institutions have already begun this task; for example,the Global Corporate Governance Forum, formed by theWorld Bank and OECD, has been debating whether it shouldallow emerging markets to “be scored against guidelinescrafted by them and shaped for their conditions, rather thanagainst standards they had no role in writing.”6

It bears noting that there are actually two distinct yetinterrelated parts to a discussion on “global standards”: first,there is the question of their existence and definition, andsecond, there is the question of how ‘global standards’ maybe achieved. The first question may look deceptively trivial,but the truth of the matter is that the very concept of ‘globalstandards’ can be notoriously difficult and controversial,therefore resulting in its susceptibility to abuse. The secondquestion, never easy to resolve for firms, is even more com-plex for policymakers, government authorities, and interna-tional governing bodies. Ignoring such complexities sur-rounding ‘global standards,’ the Korean government seemsto have decided that there exists a single set of “global stan-dards” to be pursued keenly through government policy. Thisuncritical adoption of “global standards” and its manifesta-tion in various policy measures have been based on two faultyassumptions, namely that 1) there exists a one-size-fits-allset of “global standards” which is universally applicable anddesirable, and 2) such “global standards” should be pursuedby the government through the machinery of uniform regu-lation. I shall argue that such unfounded assumptions haveprevailed in the government’s reform efforts in the post-cri-sis period.

“GLOBAL STANDARDS” AND THE INTERNATIONAL FINANCIAL

COMMUNITY

Before I proceed with “global standards” in the Koreancontext, I would like to examine the idea of “global stan-dards” as propagated by the international financial commu-nity. The international financial community has producedan abundance of documents for developing countries – sup-ply is abundant, and so is demand. It may be prudent to re-flect on Drezner’s observation that “states lacking expertise

The government’s impositionof “global standards” throughuniform rules and regulation

has been misguided.


in regulatory issues will follow the lead of a Great Powerconcert, an international organization, or a global epistemiccommunity.”7 That is, although the natural evolutionary pro-cess would generate an emergence of standards, this processis susceptible to being thwarted by the superior organizedforce of societies in which a standard has already beenclaimed. As a result, many of the issues and discussions gen-erated by international bodies are centered on what shouldnot be done, usually under the assumption that what is “right”in advanced countries should also be “right” for developingcountries. Secondly, more often than not, the recommenda-tions made by these international bod-ies contain little room for accommodat-ing the preferences of the developingcountries themselves.

Although Korea was reluctant atthe outbreak of the 1997 economic cri-sis to adopt such “global standards,”once the government decided to adoptthem, “global standards” quickly cameto be codified and imposed throughpublic policy. The case of Korea illustrates how a combina-tion of an inflexible policy recommendation by the interna-tional financial community and an eager pursuit of “globalstandards” on the part of the recipient government can eas-ily misfire. ‘Global standards,” it would appear, is an idealconcept for policymakers who believe that everyone in theworld would want to live according to the guidelines laiddown by advanced economies.

Moreover, since local business cultures and institutionsshape the way in which ideas and practices imported fromabroad are adopted by each industry and country, it is hardlylikely that “global standards,” whether in the financial sec-tor, corporate governance, or accounting practices, can sim-ply produce an outcome that is a carbon-copy of a predeter-mined model, such as the Anglo-American model. This im-plies that public policy should be flexible enough to incor-porate cultural and institutional differences rather than try-ing to simply supplant existing paradigms of economic or-ganization with those imported from abroad in a predeter-mined manner. As such, the widespread criticisms of theKorean developmental model following the Asian financialcrisis, which elicited calls for adoption of Western (particu-larly, the Anglo-American) ideals and a Western regulatorysystem, were based on the mistaken assumption that me-chanical transplantation of ‘global standards’ would betrouble-free and would automatically facilitate economicrecovery and sustained growth.

LEGACY OF KOREA’S GOVERNMENT-DIRECTED DEVELOPMENT

POLICIES

A distinguishing characteristic of Korea’s comprehen-sive industrial policy of the 1960s and 1970s was its non-compromising discriminatory function, whereby policy wasdesigned, broadly speaking, to reward top business perform-ers with special tax and financial incentives.8 It often sur-prises those grounded in neo-classical economics that gov-ernment intervention can generate such ‘miraculous’ eco-nomic growth as in the case of Korea. This puzzle is easily

solved, however, if we recognize that the main function ofmarkets is to discriminate between viable and nonviablefirms, and that what Korea’s past industrial policy achievedwas not that different from what markets would have done.In other words, the selection effect of government interven-tion, specifically, discriminating viable entities from nonvi-able ones, was what the markets themselves would haveachieved – such a process, which I call “government-led dis-crimination,” is consonant with the market evolutionary pro-cess or the “market-led discrimination” mechanism. Ofcourse, I am not suggesting that Korea should fall back and

revert to the ‘government-led discrimi-nation’ practices. On the contrary,strengthening the “market-led discrimi-nation” mechanism, as I have arguedelsewhere, is the key to Korea’s futuresustainable economic development.9

Under the successive regimes af-ter the death of President Park ChungHee in 1979, the “principle of favoringviable firms” was displaced from its

central position as the driving force behind economic change.In 1980, the new government, in reaction against the strong“discrimination” mechanism utilized by the previous authori-tarian regime, decided to put a check on the growth ofchaebols,10 Korea’s large corporations. Although slow at first,democratization quickened after 1987 and exerted pressureon economic policy to go beyond the economic dimensionand to address a broad range of social and political issues aswell. However, government intervention in the socioeco-nomic sphere continues unabated, and, moreover, uniformregulation, though with slight variations, has remained asthe undisputed instrument of economic reforms since 1987.Indeed, in consideration of this last point, I use the term “gov-ernment-led egalitarianism” to describe the mechanism un-derlying Korea’s economic evolution since 1987.11

Regulation comes in various forms, but generally, itsextension is piecemeal, sources and targets are diverse, andthe language is complex and often opaque. This does notprevent one, however, from observing that Korean-style regu-lation, whatever good intentions it may have, suffers heavilyfrom uniformity. That is, regulation is often mandated in sucha manner that it automatically and uniformly subjects a num-ber of diverse economic actors to predefined goals and stan-dards in a highly detailed and restrictive manner. This is notsurprising when one considers the fact that the Korean gov-ernment, influenced heavily by the Confucian tradition ofstatecraft, has placed the economy, including business firms’activities, under its direct responsibility. The paternalisticgovernment, refusing to discriminate among different busi-ness firms, has often found it politically “safe” to apply thesame disciplinary measures across-the-board, that is, uni-formly and indiscriminately, to all firms. As I will show ingreater detail, groups of firms are clustered and made auto-matically subject to the same special regulations irrespec-tive of how different they actually are from one another. Fur-thermore, a goal of uniform regulation seems to be the “ho-mogenization of behavior” so as to meet a predeterminedtarget (say, some set of “global standards”). Thus, when thegovernment enforces uniform regulation, the discrimination

Recommendations made byinternational bodies contain

little room for accommodatingthe preferences of thedeveloping countries

themselves.


Spring 2003

function of markets is often sacrificed for reasons of admin-istrative and political expediency rather than real economicconcerns, and market signals are largely ignored in favor ofgovernment command and control.

UNIFORM RULES AND REGULATION

The government’s handling of the corporate sector pro-vides a unique look at how ‘global standards’ and uniformregulation distort the functioning of the market mechanism.Since 1987, the Korea Fair Trade Com-mission (KFTC) 12 has ranked thechaebols and grouped them by assetsize; following this ranking, the top 30chaebols have been singled out for au-tomatic special regulations.13 Such uni-form regulations span a wide range ofbusiness activities, such as access tofunds, investment and diversificationactivities, and ownership and transaction among affiliatefirms. The KFTC, contrary to its original function of pro-moting fair trade and advocating competition, has long fo-cused on curbing chaebols’ economic power and concentra-tion.14 In fact, Leipziger notes that the KFTC “has spent toomuch time on cases of unfair trade practices, predatory pric-ing, illegal subcontracting and the like, and only 5% of itscases [are] true cases of collusive behavior.”15

Placing top performing firms under uniform regulationcreates a highly inflexible system in which the most viablefirms become automatically subject to special regulation. Thisis basically the opposite of the ‘government-led discrimina-tion’ mechanism of the 1960s and 1970s, and also of themarket discrimination mechanism. Interestingly, in order toavoid the frustration of such a uniform regulation, firms havecompeted with each other to stay out of the regulated top 30– thus, there is an incentive to sacrifice performance, or toengage in false reporting, just enough to keep out of the regu-lated group of firms. To put it in crude terms, the KFTC’sregulatory framework systematically threatens any firm thatwill find itself in the group of top 30 in the following year.This is indeed a misguided incentive system.

And yet, this is only half the story. Because the KFTC’sregulatory framework seeks uniformity across a spectrumof firms, it has a high propensity to diminish the diversityand freedom of economic actors, which is an indispensableelement of the market discrimination mechanism. Such mea-sures, which force a variety of firms to abide by the samearbitrary standards, wrongly presume that all the firms shouldbehave identically irrespective of differences in their indi-vidual business strategies and motives. Although a corpo-rate disciplinary body should exist, the current regime ofuniform regulation continues to frustrate Korea’s transitionto a market-oriented economy and, moreover, may have donelittle to help improve Korea’s competitiveness.16

IN SEARCH OF “GLOBAL STANDARDS”

Anglo-American Corporate Governance System

A clear case of the attempt to achieve “global standards”in Korea is the full-scale introduction of the Anglo-Ameri-

can corporate governance system as part of the post-crisisreform efforts,17 which amongst other things emphasizesshareholder rights and interests, increased transparency anddisclosure, and incorporation of outside board of directorsand independent auditing boards. The new corporate gover-nance code in Korea, largely based on the OECD Principlesof Corporate Governance,18 is about 40 pages long and cov-ers each aspect of governance.19 However, many details ex-pressed in the code arguably do not belong in the realm ofpublic policy. Irrespective of the merits per se of the Anglo-

American system, it seems intuitivelywrong to simply assume that Koreancorporations, in their efforts to becomecompetitive, must adopt the Anglo-American standards and ideals in toto.Historical, cultural, and institutional dif-ferences exist between Korea and theWest that make it difficult to expect thatmechanical transplantation of Anglo-

American corporate features will work effectively for Ko-rean corporations. This, of course, does not discount thepossibility that Korean corporations may evolve in the fu-ture so as to benefit from adopting some features of theAnglo-American corporate governance system, such as dif-fused ownership, a strong Board of Directors, less depen-dence on debt financing, and so on. However, history showsthat the future is highly uncertain – predicting what form ofgovernance structure will evolve in the future is neither easynor simple. Most importantly, one needs to exercise patienceand allow the market mechanism to determine what featuresof corporate governance structures will prove to be success-ful in the Korean context. It seems prudent, therefore, thatpublic policy should try granting each firm greater freedomto decide on the intricate details of its own corporate gover-nance structure that are compatible with its corporate strate-gies; imposing detailed targets so as to implant features ofthe Anglo-American system through uniform regulation in-herently assumes more than is possible.

The Board of Directors (BOD) System

Among the many detailed and narrow restrictions ofKorea’s corporate governance code, it is required that theBOD system be introduced to all listed firms, with compul-sory rules for the exact composition and functions of out-side or non-executive directors. As it stands now, it is man-datory that at least a quarter of the BOD (and half for largelisted firms) be independent outside directors. In the US,BOD members are usually representatives of a large num-ber of shareholders and are supposed to follow the goal ofmaximizing shareholder value, as the US system, after all,places stockholders as the most important stakeholders incompanies. In Korea, however, owing to historical differ-ences, the owner-manager is usually placed at the center ofthe company, and other shareholders have been relativelyunimportant both as a source of finance and in influencingmanagement decisions. In a sense, Korea is somewhat closerto Germany and France, where social capitalism has had along tradition and the BOD represents special interest groupsand managers to a greater extent than does the BOD in the

The KFTC’s regulatoryframework systematicallythreatens any firm that willfind itself in the top 30 the

following year.


US or the UK.20 Therefore, there seems to be little reasonwhy corporations should not be allowed flexibility in deter-mining the composition of its board. After all, demandingthat Korean firms abide by an overly detailed set of uniformregulations has the potential to raise compliance costs andother expenses, deter innovation and risk-taking, increaselawsuits, and distract CEOs and executives from other im-portant tasks.

Furthermore, it seems that the introduction of a uniformBOD system for Korean corporations is not unrelated to thegovernment’s ambition to separate own-ership and control, which apparently hasproven to be difficult because owner-ship structure is intricately embedded inthe country’s business culture and tra-dition. The concentration of ownershipin Korea, which results from a long tra-dition of weak property rights protec-tion, as well as the dominance of a bank-based financial system characterized by relationship bank-ing, have meant that disclosure and transparency have beenrelegated to a somewhat secondary priority. The OECD Prin-ciples tend to disregard such features that have so far servedKorea well, and, because their focus is on “governance is-sues that result from the separation of ownership and con-trol,”21 the Principles tend to over-emphasize the protectionof shareholder rights over other stakeholders’ interests. Forexample, recognizing this tendency in US corporate gover-nance, Germany maintains that board practices need not bedisclosed, except for the composition of supervisory boards,and that financial results of only some listed companies areto be disclosed on a quarterly basis. Therefore, I suggestthat Korean firms deserve a more appropriate BOD systemby means of which shareholders’ value as well as themanagement’s discretionary function can be maximized.

200% Debt-Equity Ratio

One more illustration of the dangers of Korea’s uniformregulatory regime is the 200% debt-equity ratio requirementimposed on the chaebols in 1998. Essentially, the debt-eq-uity ratio shows how much leverage, or debt, a company iscarrying compared to its shareholders’ equity, and in gen-eral, the lower the figure, the stronger the firm’s financialposition in cushioning any adverse effects of the businesscycle.22 It is therefore an important variable that potentialinvestors consider when deciding whether to invest. How-ever, uniformly requiring corporations to reduce debt-eq-uity ratios, even if the purpose is to help provide a ‘better’picture of a corporation’s financial health to outside observ-ers, investors, or the international financial community,makes the critical mistake of equalizing debt-equity ratiosacross industries and firms. This approach, therefore, maymake the debt-equity ratio a misleading or distorted finan-cial indicator.

Furthermore, an underdeveloped equity market and de-pendence on bank loans to finance business activities havecharacterized Korea’s bank-based financial system. This, to-gether with other features of the country’s political and in-stitutional environment, has resulted in high debt-equity ra-

tios in the corporate sector.23 Whether or not high debt-eq-uity ratios constituted a primary cause of the financial crisis,the high leverage of the chaebols24 in particular came underserious attack, and all chaebols were required to reduce theirleverage to a predetermined 200% debt-equity ratio by theend of 1999. By early 2000, in just three years, debt-equityratios for most chaebols were below the 200% requirement.It still remains to be verified how much of this ‘impressive’achievement can be attributed to real structural change ratherthan accounting manipulations. As for now, the real objec-

tive of the reform, i.e., enhancing cor-porate competitiveness, seems to havebeen somewhat lost in the maze ofpolicy targets.

The requirement to bring downdebt-equity ratios to 200% across-the-board has already adversely constrainedmany Korean firms. This is especiallytrue for those firms in industries such

as construction and oil refining, which, by the nature of theirbusinesses, have relied relatively more on debt financing forgrowth and investment. An acceptable debt load variesamong corporations and among industries as well as amongcountries. Depending on industrial specifications, corporateobjectives, and a multitude of other factors, the optimal levelof debt differs among firms. In the rush to meet mandatoryrequirements, firms may act in a manner that is not alwaysdesirable. For example, rather than repaying corporate debtsby asset sales and new stock issues, corporations often issuenew stock among their subsidiaries and revalue their assets,which increase ownership concentration. The government,not surprisingly, has recently turned its attention to tacklingthis issue and has decided not to allow 19 conglomerates,whose assets were valued at more than W5 trillion as of April1, 2002, to make investments over 25% of their net worth inaffiliate firms.25 This type of regulatory practice, as pointedout earlier, addresses symptoms rather than helping solvethe real cause of the problem.

DISCOVERING TRUE “GLOBAL STANDARDS”

Since I have claimed that 1) “one size does not fit all,”which means that the Anglo-American system should not beimposed on developing economies as the one, true standard,and 2) care should be taken when trying to implement a“proven” international code of best practice, readers mightlike to know of an alternative approach to “global standards.”I propose that better standards and business practices canand should be discovered through market competition. Thatis, standards, whether global or local, should never precedemarket competition, but rather, if they are to contribute tosustainable economic growth, should be defined as a resultof actions by economic actors under conditions of free com-petition and rivalry. To come up with better corporate gov-ernance standards, for example, it would be necessary to leteach corporation decide on the details of its corporate gov-ernance structures in line with its strategies, and then let themarket mechanism determine the success or failure of suchdecisions. This approach has two advantages: 1) it will fa-cilitate the transition to better standards and business prac-

Korean firms deserve a moreappropriate BOD system

where both shareholder valueand management discretion

can be maximized.


Spring 2003

tices, as each firm will strive to outperform its rivals; and 2)it will promote dynamism in the market mechanism by re-warding better decisions and strategies that result in improvedstandards.

We should further acknowledge the important influencesthat existing institutional, legal and cultural differences ex-ert on business practices and standards. For example, as men-tioned earlier, Korea’s corporate governance code in the midstof the financial crisis came to be restructured along the linesof the Anglo-American system, in which agency theory26

forms a basis for understanding corporate governance is-sues, such as those centering on separation of ownership andcontrol. Agency theory posits inherent conflicts of interestbetween owners and managers, and thus calls for institu-tions, policies and proce-dures that can protect share-holders’ interests. Despiteits merits, however, theagency theory is not theonly approach to corporategovernance. For example,the cultural embeddednessmodel27 takes an approachmore expansive than justmitigating agency prob-lems, noting that differencesin corporate governanceexist among countries re-flecting institutional andcultural variance. These dif-ferences arise from vari-ables such as the type of fi-nancial system in theeconomy, the country’s socialization experiences, the roleof relationship-based commercial activities, participation bya firm’s creditors in its management, and the extent of dis-closure requirements.

Only when certain practices stand the test of time dothey become accepted as standards. For “global” to precede“standards” as in the phrase “global standards,” rivalry andcompetition among different standards should take place ona global scale.28 The adoption of governance principles mustbe left up to the corporations themselves, who will need toselect from a pool of available principles only those featuresthat are suited to their particular circumstances and needs.This does not, of course, rule out the possibility for govern-ment policy to augment business strategies and standards;however, even here, government policy must not be imposedvia uniform regulation but, rather, aim at improving marketefficiency by means of market-conforming intervention.

PUBLIC POLICY OR CORPORATE STRATEGY?

To make this discussion more concrete, it may be use-ful to elaborate a little on the differences between publicpolicy and corporate strategy in the real world. For example,many analysts believe that Korea’s stock prices are gener-ally undervalued due to a lack of management transpar-ency,29 and that the stock market can be improved if corpo-rate governance structures were augmented. However, iden-

tifying a problem is one thing, and taking measures to solveit is another. A widely held view is that public policy shouldencourage transparency, say, by mandating a well-defineddisclosure system, by having non-executive directors andbetter accounting standards, and so on. But, as I have ar-gued, when it comes to policy implementation, Koreanpolicymakers tend to engage in “uniform regulation,” asthey go far beyond making general recommendations orsetting broad guidelines and actually lay down detailed regu-lations and apply these uniformly to different industries andfirms. This means that improving management transparencyand corporate governance is a tough task for a Korean gov-ernment that is so used to its traditional methods of “uni-form regulation.” Therefore, if the government were to be-

come serious about mean-ingful reforms in corporategovernance, it must ac-knowledge its limitationsand leave up to the discre-tion of managers such inte-gral questions of corporatestrategy as the role and com-position of the BOD, thenumber of independent au-ditors, and the extent oftransparency in the disclo-sure system. 30

It is important to pointout that national policy hasno room for mistakes, as itcannot afford to put thenation’s economy and itscitizens at risk. If a national

policy that focuses on enforcing a uniform strategy in thecorporate sector goes wrong, then the whole nationaleconomy will be doomed to failure. We might recall that itwas not so long ago when Japanese business practices werethe envy of the business community worldwide.31 The USat the time was grappling with the weaknesses of its corpo-rate governance system that tends to focus on short-termprofits in order to meet powerful shareholders’ demandsfor higher dividends. With Japan’s economic performanceovertaking that of the US in the late 1980s, many observersregarded the Japanese corporate governance system, whichfocused on long-term investment and seemed to derive itsadvantage from the more stable and closer relationshipsbetween banks and corporations, as the “global standard”at the time. One can imagine what would have happened ifthe US had proceeded to adopt Japanese standards and en-force them uniformly on all US industries and corporations.

CONCLUDING REMARKS

The debate over “global standards” is both complex andcontentious. In this essay, I have referred to some of the manyoutstanding issues in Korea’s corporate sector, where theapplication of “global standards” has become contaminatedby various myths and misconceptions. Although it may bepremature to make a definite assessment, initial signs indi-cate that the post-crisis economic restructuring has led to

Should Korea really conform to “global standards”? (photocourtesy of www.photoshutter.com)


mediocre results in improving corporate governance and mayalso have done little to improve corporate competitiveness.32

Moreover, the rationale for corporate reform based onthe presumed adequacy of “global standards” needs to bequestioned. Although on the surface there have been sig-nificant changes to Korea’s corporate governance in line withWestern standards, when one “lifts the corporate veil,” ar-guably not much has changed. In fact, many of Korea’s cor-porate reform efforts have had ambivalent consequenceswhen it comes to instilling greater market discipline. It isapparent to many domestic and international observers thatthe government, rather than relying on market institutionswith better incentives for sounder decisions (for example,better regulatory practices, transparent accounting systems,more efficient bankruptcy procedures, an improved legalframework for mergers and acquisitions, and so on), has in-stead carried out measures that seek to impose specific pre-determined outcomes – e.g., 200% debt-equity ratios, impo-sition of the Anglo-American corporate governance system,and independent directors making up half of BOD members– in a way which undermines its commitment to free mar-kets. This heavy-handed and misguided approach can beinterpreted as a sign that the government has little faith inthe ability of the market mechanism to adequately solve ex-isting economic difficulties.

More importantly, I have drawn attention to the poten-tial dangers of the marriage of uniform regulation typical ofdeveloping countries (in their attempt to force structuralchange) with one-size-fits-all “global standards”; such a mar-riage vitiates the market discrimination mechanism. Thisarticle shows that it is not only misguided but also difficultto impose predefined “global standards” through uniformregulation. What I advocate is that better business standardsand norms can arise only as a result of free competition andrivalry among various economic actors as well as amongdifferent standards, both local and global. Although Confu-cianism teaches that “optimism is the faith that leads toachievement,” one must take care not to be blinded by anunfounded optimism, which seems to be common behindmany well-intentioned but misguided government policiespremised on the correctness of uniformly applying “globalstandards” to Korean industries and corporations.

ENDNOTES

1 Economic reform includes opening up the economy, priceand interest rate liberalization, promotion of small- and me-dium-sized enterprises, mitigating the domination of theeconomy by large corporations, and so on.2 If we break down the TFP figures into their constituentparts such as efficiency of resource allocation, economies ofscale, and so on, a similar declining rate is observed.3 Of course, this is not to say that there have been absolutelyno improvements in the economy and Korean society in thepast twenty years or so. Economic policy unambiguouslybrought about Korea’s ‘miraculous’ economic growth of the1960s and 1970s. However, despite economic reforms in thelater 1980s and 1990s, the phenomenal success of the initialtwo decades was not repeated, let alone surpassed.4 Notwithstanding the widespread use of the term ‘globalstandards’ in the news media, I have yet to find a singleserious academic study in the economics literature that at-tempts to critically examine this term.5 Or, more precisely those that adhere to the so-called ‘Wash-ington Consensus.’6 Global Proxy Watch, ‘Stumble,’ January 14, 2000.7 Daniel Drezner, ‘Who Rules? State Power and the Struc-ture of Global Regulation,’ Paper presented at the AnnualMeeting of the American Political Science Association, SanFrancisco, September 2, 2001, p. 18.8 See, for example, Howard Pack, ‘Industrial Policy: Growthand Elixir or Poison?’ The World Bank Research Observer,vol. 15, no.1, February 2000.9 See Sung-Hee Jwa, The Evolution of Large Corporationsin Korea: A New-Institutional Economics Perspective of theChaebol (London: Edward Elgars, 2002), chapter 7.10 Note that the term ‘chaebol’ is not a legal concept.11 So, in my explanatory framework, there are three distinctevolutionary mechanisms behind Korea’s economic devel-opment, i.e., ‘government-led discrimination’ of the 1960sand 1970s, ‘government-led egalitarianism’ since 1987 tothe present, and, it is hoped, ‘market-led discrimination’ soonto be established as the driving force behind Korea’s futureeconomic development.12 The KFTC was established in 1981 and is the main bodyoverseeing the Regulations on Monopoly and Unfair TradePractices enacted in 1980.13 Starting April 1, 2002, in a change from the previous policythat ranked the chaebols by asset size, all Korean firms werenow placed under the special regulations if their total assetsexceeded 2 trillion Won. This ‘new’ system, in essence, doesnothing to weaken the arguments I make here.14 See Jwa (2002), ibid, chapter 2.15 Danny Leipziger, ‘The Global Standards and Korea’s Eco-nomic Reform,’ Journal of International and Area Studies,Vol. 6, No. 2 (1999), pp. 1-18.16 As mentioned in the introduction, the TFP growth ratesfor the post-1987 period have been lower than those for the1960s and 1970s.17 Regarding Korea’s corporate sector, the Kim Dae Jungadministration set up the ‘Five Principles of Structural Re-forms of Corporations,’ effective starting January 1998, inorder to ‘guide’ reform in the corporate sector. The Prin-


Spring 2003

ciples include 1) improving management transparency; 2)eliminating debt-payment guarantees between affiliate firmsof a chaebol group; 3) improving the corporation’s capitalstructure; 4) focusing on core businesses; and 5) enhancingthe accountability of controlling shareholders and manage-ment. Three more principles were announced in August 1999,which include prohibiting: 1) interlocking equity investmentsamong group affiliates; 2) illicit deals among group affili-ates; and 3) ‘unreasonable’ bequests. Many specific mea-sures have been established to achieve these Principles plusother objectives that were not officially announced, such ascurbing business diversification, separating ownership andcontrol, separating non-financial and financial firms, and soon.18 See ‘OECD Principles of Corporate Governance’ (1999),which can be downloaded from: www.oecd.org/daf/gover-nance/principles.html19 Interestingly, Russia has a ‘Code of Corporate Conduct,’which is 68 pages of detailed recommendations and proce-dures reflecting international best practices. The US untilrecently did not have a formal code, i.e., until the Sarbanes-Oxley Act of 2002, while state corporate governance stat-utes seem to have been redundant at best.20 See Bauer, ‘Between the State and the Market: the FrenchBusiness Elite,’ International Sociological Association pa-per (1990), for an example about the BOD system in France.21 See OECD (1999), ibid.22 Interestingly, the Modigliani-Miller (M-M) theorem statesthat the market value of any firm and the average cost of itscapital are independent of its capital structure. Essentially,the M-M theorem argues that, in an efficient capital marketwith no tax distortions, the relative proportion of debt andequity in the capital structure of a corporation does not af-fect the total market value of the firm, and that, as such,debt-equity ratios should not necessarily affect acorporation’s default risk. However, this theorem cannot beexpected to hold in the real world, which is characterized byinformation asymmetry, tax distortions, and of course, pe-rennial government intervention that seeks to distort themarket signals one can expect in unregulated markets.23 The Anglo-American capital market-based financial sys-tem allows for a lower debt-equity ratio. This can be com-pared to the Japanese and German (and Korean) bank-basedfinancial system that would call for higher debt-equity ra-tios.24 For example, the average debt-equity ratio of the top 30chaebols stood at 502.9% in 1997.25 Forty-three smaller groups have also been banned frommaking cross-subsidiary investments and debt guaranteesamong group affiliates.26 See, for example, Jensen and Meckling, ‘Theory of theFirm: Managerial Behaviour, Agency Costs and OwnershipStructure,’ Journal of Financial Economics, Vol. 3 (1976),pp. 305-60; and Shleifer and Vishny, ‘A Survey of Corpo-rate Governance,’ Journal of Finance, Vol. 52, No. 2 (1997),pp.737-83.27 See, for example, Charkham, Keeping Good Company: AStudy of Corporate Governance in Five Countries (Oxford:Clarendon Press, 1994); Lutbatkin et al., ‘A National Em-bedded Model of Corporate Governance,’ Working Paper,

University of Connecticut (Storrs, CT: 2001); and Roe, ‘SomeDifferences in Corporate Structure in Germany, Japan, andthe United States,’ Yale Law Journal, Vol. 102, No. 8 (1993),pp. 1927-2003.28 For example, in the area of corporate governance, we mighthave the Anglo-American system versus the UK system ver-sus the Franco-German system versus the Japanese systemversus the Korean system, etc.29 Incidentally, Korea recently scored rather poorly, ranking16th out of 25 emerging economies, according to a report in2001 by Credit Lyonnais Securities Asia (CLSA) and Stan-dard & Poor that evaluated individual companies accordingto their level of corporate governance.30 Alan Greenspan has recently argued that secrecy or lim-ited disclosure may be important in realizing certain socialbenefits and that regulations on disclosure may indeed hurtinnovation and profit. See Alan Greenspan, ‘Regulation, In-novation and Wealth Creation,’ Remarks Before the Societyof Business Economists, London, September 25, 2002.31 See Ezra Vogel, Japan as Number One: Lessons forAmerica (New York: Harper and Row, 1980).32 See, for example, Seung-Rok Park, ‘Economic Perfor-mance of Korean Firms and Evaluation of RestructuringTools During Financial Crisis,’ mimeo (Seoul: Korea Eco-nomic Research Institute, 2003). TFP growth for the top 30chaebols in the post-crisis period drops by half to 1.2% in1999/2000 compared to 2.4% in 1996/1997. TFP growth forthe same two periods for public firms and other non-chaebolfirms also falls from 2.7% to 2.2% and 2.8% to 2.4%, re-spectively.


WHY JAPAN CANNOT REFORM: SOCIALCONTRACT AND THE WELFARE SYSTEM

Japan has always looked like a country of contradictions, but the eco-nomic reforms of the late 20th and early 21st centuries are perhapssecond to none. As Japan’s government is introducing new reform

measures in rapid succession to clean up the bad loan problem and torestructure industry, it is also increasingly adopting market-interveningmeasures to protect the very subjects targeted by reform. For example,beginning in late 2002, the Bank of Japan (the central bank) began buy-ing large firms’ shares from large banks, to infuse capital and keep bothafloat. Earlier in the same year, Minister Takenaka, in charge of financialrestructuring, requested that banks accelerate their clean-up, but the gov-ernment also introduced loan guarantees for small firms and requestedthat large banks increase their lending to these small firms.1

As a result, with every step forward towards adopting more market-oriented measures – which is the explicit goal of Minister Takenaka –Japan seems to be taking at least a half step backwards. Mr. Takenaka’splan is to reorganize and rejuvenate the banking system and the industrialstructure, so as to allow young firms easier access to capital and helplarge, healthy firms to drive the country’s economic recovery. However,other parts of the government – namely, the various ministries in chargeof certain industries such as retail, construction, or transportation – arestructuring protective measures aimed to save firms from the disciplineof the market. In addition, these protective measures are not simply wel-fare transfers: they are implemented through increased government par-ticipation in the market, e.g., through subsidized loans offered by gov-ernment banks to small firms. One might argue whether Japan is reallybest served by more market orientation; this, however, is not the point ofthis paper, since Minister Takenaka, with the backing of Prime MinisterKoizumi, is already committed to this course of action. Rather, the issuehere is why Japan is adopting these contradictory measures that have sofar stalled most reform programs.

This paper argues that the main reasons for the government’s ten-dency to introduce protective measures to counterbalance the effects ofmarket reforms are an insufficient welfare system and Japan’s existingsocial contract, which does not tolerate uncertainty and social suffering.For Japan to truly move towards more market orientation, some large andmany small firms would have to be weeded out, thus leading to higherstructural, and therefore long-term, unemployment. While Japan’s un-employment insurance – which covers an unemployed individual for amaximum of 330 days – was recently restructured and seems to function,there is a huge welfare gap for the long-term unemployed. Thus, if some-body were to be laid off in his early 50s, he would have to rely on hissavings until he qualified for a pension, however meager, at age 65. Womenare mostly hired as so-called “part-timers” and as such cannot claim un-employment insurance or pension benefits; only in March 2003 was achange made so that part-timers qualify for partial pension. Re-employ-ment would be particularly difficult for previous owners of the smallestfirms in the service and manufacturing sectors, such as tatami (rice strawmat) makers, public bathhouse operators, or fourth-tier suppliers of auto-mobile and electronics parts. In fact, these very small firms are a hugepart of the problem. While dominant in number, these firms are not usu-ally well off to begin with, and now find themselves without assets, com-

BY ULRIKE SCHAEDE

Ulrike Schaede is Associate Professor of Interna-tional and Pacific Affairs at the Graduate Schoolof International Relations and Pacific Studies (IR/PS), the University of California, San Diego. She isthe author of Cooperative Capitalism: Self-Regu-lation, Trade Associations, and the AntimonopolyLaw in Japan (Oxford UP, 2000) and numerousother books and articles. Schaede’s research in-terests include Japan’s government-business re-lationship, industrial policy, corporate strategy, andfinancial regulation. After earning her Ph.D. in Ger-many, she has spent a total of 6 years conductingresearch in Tokyo, including visiting appointmentsat Hitotsubashi University, the Ministry of Finance,and the Ministry of International Trade and Indus-try. Her current research focuses on small firm fi-nance, both private and public, and recent shiftsin Japan’s small firm policies, including venturecapital market initiatives.


Spring 2003

petitive capabilities, or a safety net after years of recession.Japanese small firms are central to the country’s soci-

ety, and now also to its economic reforms, in ways differentfrom most other nations. More than 99% of Japanese com-panies are small (defined as having fewer than 300 employ-ees or capital of less than ¥300 million), but more impor-tantly, 75% of Japanese firms are “very small,” with fewerthan 20 employees in manufacturing, or fewer than five em-ployees in distribution and services. These very small firmsemploy more than 20% of the workforce, and almost half ofthe construction industry workforce (not counting “part-tim-ers,” i.e., women, who account for a large portion of smallfirm employees).

Knowing that small firm ownersand employees on average can live ontheir savings for perhaps four years,and being aware that the current na-tional welfare system is not equippedfor this situation, Japan’s governmentis attempting to compensate for this de-ficiency by artificially keeping manycompanies in business through subsidy programs. Rather thandesigning an incomes policy that is market- and price-neu-tral (by collecting taxes and granting welfare checks), theJapanese government is participating in the market throughsubsidized loans and other projects that erode the effects ofmarket-oriented reforms.

As long as this course of action prevails, Japan will beunable to reform. Foreign analysts, as well-meaning as theiradvice is intended to be (e.g., Krugman 2002, Posen 1998),must not neglect the role of small firms in Japan’s economyand society, lest they fall into the trap of simply starting withimplicit assumptions about their own economy and general-izing to solutions that a more sophisticated understandingwould reveal as inappropriate or incomplete. The root causeof Japan’s dilemma is that the government is unprepared tolive up to its responsibilities within the country’s currentsocial contract in market-conforming ways; in other words,the Japanese government is unable to let go of its old waysof guiding the markets. The government will only be able toimplement true market-oriented reforms if it is also willingto provide market-based welfare benefits to the long-term,structurally unemployed. As long as the government balksat this responsibility, it will have to continue protecting inef-ficient and de facto bankrupt firms, especially those withmany employees or suppliers, from its own reform measures.

JAPAN’S SOCIAL CONTRACT

A social contract is a covenant, usually not codified, bywhich the relationship between society and state is defined.Its origins can be traced to the Greek sophists and later thegreat state philosophers of the 17th and 18th centuries (e.g.,Locke and Rousseau), who were trying to come to grips withthe relative roles of citizens and the state as well as the le-gitimacy of the state’s authority. In contemporary use, theconcept is often more narrowly applied to incomes policy.In particular, it addresses the question of how many servicesthe government has to provide in return for its right to re-duce citizens’ incomes, whether through high taxes, high

prices, or other means. Reflecting significant differences inbasic societal assumptions and preferences as well as politi-cal and economic struggles within and across nations, coun-tries differ in how they have crafted this social contract overthe course of their histories. In postwar West Germany, forexample, the covenant agreed upon by state, taxpayers, busi-nesses and labor was that the state would reduce householdincomes and tax companies, as the price for a reliable andcomparatively generous social security system, free educa-tion, social stability, and basic health care.

A social contract, developed over time and inclusive ofa country’s primary interests as well as societal norms and

values, is difficult to change, either in-crementally or radically (Olson 1982).This is not only because the contractis not spelled out and signed, and nei-ther is it just because of the economiclogic that existing agreements on gov-ernment transfers (such as subsidies,welfare payments, etc.) have createdvested interests that oppose change.

Rather, it is because a change in the covenant requires achange in the fundamental values and implicit contracts inthe society – something that was not seen in Japan in 2003.Instead, as the recession continued, Japanese citizens seemedto be ever more concerned with economic security and sta-bility.

Japan is not the only country, of course, where the ex-isting social contract has created barriers to the change neededfor a successful transition to a post-industrial society. Forexample, many in the US are unhappy with a system where,in spite of significant national wealth, more than 40 millionpeople are without health insurance. In Germany, a gener-ous welfare system has created incentives against working,and it is beginning to bankrupt the country. In the face ofsuch evident problems, doing something about the social con-tract, the interests vested in it, and the societal values it re-flects, is an enormous challenge. Such a change would re-quire a transformation of the values and reciprocal deals thatsociety would have to agree on, and politicians who are will-ing to look 50 years ahead (instead of just to the next elec-tion) to push it through. For these reasons, it is unlikely thatJapan will change its social contract to fight the current re-cession.

JA PA N’S S OCIAL CONTRACT I N THE PERIOD OF POSTWAR

GROWTH

The story of Japan’s postwar economic growth and suc-cess has been well told (Nakamura 1981, Johnson 1982).Through strict financial regulation, the government assumeda huge role in promoting economic growth. It channeledfunds to “strategic industries” that were oriented toward ex-port markets. In the 1950s and 1960s, these were steel, en-ergy, heavy machinery, petrochemicals, chemicals, and ship-building. Within a short time, their fast growth transformedJapan’s economy from an exporter of toys and textiles into aheavily polluting economic juggernaut. The 1973 oil crisisthen triggered a feat of industrial restructuring; after a singledecade of recession and suffering, Japan emerged as a world

The government is unpreparedto live up to its responsibilities

within the current socialcontract in market-conforming

ways.


leader in precision machinery, electronics, cars, banking andinsurance. Underlying this stunning performance were a pro-ducer-oriented policy of keeping costs of borrowing low; aflexible, informal regulatory system based on close ties be-tween businessmen and bureaucrats; a stable political sys-tem; a high savings rate; hard-working, well-educated people;advanced corporate skill formation techniques; a supportiveworld economy; a lot of managerial ingenuity; and maybe alittle bit of luck.

Based on the interests of the dominant economic actorsof the immediate postwar years – large businesses, bureau-crats with war-economy experience, and politicians – a so-cial contract emerged that centered onproducer-oriented policies and largefirms. The notion was that if largefirms could grow fast, they could pro-vide employment and carry the rest ofthe economy with them; even if largefirms accounted for only a third of to-tal employment, over time the smallfirms would benefit from large firmsspearheading development. This fast growth of large firmswas supported by a series of policies including maintaininglow interest rates (to keep the cost of borrowing low) andallowing large firms to charge high prices (by way of lim-ited antitrust enforcement and proactive government guid-ance on uniform price-setting; Schaede 2000). In return, largefirms offered “lifetime employment,” not as a contract orlegal obligation but as a social norm, understood as the pricefor their privileges in the system. At the time of early retire-ment in their mid-50s, “lifetime” employees received a lump-sum “pension payment” averaging two-to-three times theirannual salaries, and were then helped to find continuing em-ployment in smaller firms that were usually affiliated withthe original employer. This continued employment, in com-bination with the lump-sum pension payouts, served to in-crease employees’ lifetime incomes.

This system, combined with rapid economic growth,made a national, fully-fledged pension and welfare systemless essential, even for small firm employees. Pension pay-ments remained comparatively low, and were intended tosupplement the post-retirement income of an employee,rather than be the sole source of income. The system of life-time employment also greatly reduced the need for a com-prehensive unemployment insurance system. Only in 1973did the government begin to tackle the issue of building asocial security system, though initial efforts were soonthwarted by the 1973 oil shock. Government pension payoutsand the welfare system in Japan remain limited today.

For households, the social contract tradeoff was socialstability at the price of low real incomes (low returns onsavings, low wages, and high prices). Stable employmentled to greater income certainty and higher quality education.Sustained high growth rates meant that life was getting bet-ter as households benefited indirectly from a gradually im-proving infrastructure. Households largely agreed to pro-ducer-oriented policies and cartels because they highly val-ued stable employment and social development. The Lib-eral Democratic Party held power without interruption be-tween 1955 and 1993.

The social norms and values underlying this covenantwere risk aversion, social stability, perceived income equality(expressed in repeated public questionnaires, yoron chôsa,in the 1970s and 1980s, when 90% of households regularlyconsidered themselves “middle class”), education, and safety.In this system, no huge bankruptcies occured, and no socialunrest was fueled. Everybody proclaimed to be working ashard as possible, all under the heading of a common effortfor the common good.

This interpretation of Japan’s social contract is basedon a synthesis of numerous writings by Japanese authors onthe country’s postwar success, and is also often reflected in

political speeches and corporate pub-lic statements. As is true for socialcontracts everywhere, there were dis-sidents. Furthermore, some parts ofsociety were overlooked in this ar-rangement. In particular, there waslittle if any room in this covenant forone group that is both large and argu-ably the most crucial for economic re-

form in the 21st century: the small and very small firms. Aslong as macroeconomic conditions remained strong, smallfirms benefited indirectly, but since the 1990s it has becomeclear that they are outsiders in this system.

SMALL FIRMS IN JAPAN

Until 1999, “small firms” in Japan were defined as manu-facturing firms with capital of less than ¥100 million and/orfewer than 300 employees; for the wholesale, retail and ser-vices industries, the limits were significantly lower. Giveneconomic growth and industrial change, these limits wereraised through a 1999 reform of the “Small and MediumEnterprise Basic Law,” so that manufacturing firms now are“small” if they have capital of less than ¥300 million and/orfewer than 300 employees.2 There is no legal definition forvery small firms. In official statistics, e.g., those producedby the Ministry of Economy, Trade and Industry (METI)Small- and Medium-Sized Enterprise Agency, these are con-sidered to have fewer than 20 employees in manufacturing,and fewer than five employees in wholesale, retail, food andservices.3

Figures 1 and 2 illustrate the current situation of smallversus large firms in Japan. Figure 1 highlights the situationoften referred to as Japan’s “dual structure”: large firms, whileaccounting for less than 1% of all firms, employ about 20%of the workforce. It is this 20% of the workforce (plus thosein the government and public firms, which are not includedin the data), plus the employees of the primary suppliers tothese large firms, that have gotten used to the expectation of“lifetime employment” in the postwar period. Looking atthe data by industry, we see in Figure 2 that the very smallfirms are most important in the construction industry, wherethey account for 95% of the firms and employ 45% of allworkers. Other industries where very small firms stand outare, not surprisingly, restaurants and food services.

Separate data also show that in 1997, small firms ac-counted for 55.7% of value added, and 50.8% of shipmentsin manufacturing, 64.2% of shipments in wholesale, and

Under strong macroeconomicconditions small firms benefitedindirectly, but since the 1990s ithas become clear that they are

outsiders in this system.


Spring 2003

75.7% of shipments in retail.4 Overall, the two figures un-derscore that Japan’s industry is indeed dominated by smallfirms.

International comparisons are complicated and easilycause misinterpretation. The definition of a “small” firm dif-fers across countries, and in the US the definition also dif-fers greatly across industries and policy issues. Roughlyspeaking, in the US, manufacturing small firms are definedas those with fewer than 500 employees (1000 in automo-biles, and 1500 in aircraft). In construction, “small firms”are those with 700-1700 employees – this is more than fivetimes the limit used in Japan. In general, US limits for whatis “small” are much higher than in Japan.5

In Europe, Germany has traditionally been somewhatcloser to Japan in its definition of “medium firms” (definedas those with fewer than 500 employees or annual sales ofless than DM 100 million), and “small firms” (fewer than 9employees or sales of less than DM 1 million). In 1996, theEU developed its own definition of a “small firm” as onewith fewer than 250 employees or annual sales of less than10 million Euro.6

In addition to these definitional differences, there arealso great discrepancies in the societal and economic stand-

ing of “very small firms.” Official data indicate that in theUS, as of 1995, 98% of firms were “small,” employing 53%of the workforce and contributing roughly 47% of GDP.While this seems to be similar to Japan, note that in additionto the larger size limits on “small,” the US tax system setsincentives for individual professionals to become“proprietorships.” Of the total of 22.6 million US firms in1995, only 6.4 million firms had any employees at all.7

Using the EU definition of fewer than 250 employees,in Germany in 1996, 99.6% of firms were “small” employ-ing 57% of the workforce. Germany, therefore, is in a situa-tion similar to Japan, with the important difference thatGermany’s social contract is clearly geared towards smallfirms.

In Japan, the “very small firms” are not usually madeup of highly skilled consultants, lawyers or other profes-sionals, but rather establishments with two or three less-skilled employees. These could be startup firms and suc-cessful small businesses, but importantly this group also in-cludes numerous traditional, small-scale industries such astatami (rice straw mat) weaving, tôfu, and small plastic (lac-quer) ware production. Such firms also include the smallstationery and grocery stores, public bath houses and what

Figure 1: Private Large Firms vs. Small Firms, 1991and 1999 Comparison**Source: METI SME Agency (2002a), pp. 397-401

of which:

# % of total # % of total # % of total # % of totalNumber of 1991 6,541,741 100.0 57,445 0.9 6,484,296 99.1 4,901,641 74.9Business Places* 1999 6,184,829 100.0 45,094 0.7 6,139,735 99.3 4,514,464 73.0

Number of 1991 54,791,827 100.0 11,392,533 20.8 43,399,294 79.2 15,565,550 28.4Employees 1999 53,590,313 100.0 10,395,532 19.4 43,194,781 80.6 13,835,301 25.8

* Business places (jigyousho ) include firms plus branches, plants, outlets, etc.**Data are for private firms only, excluding agriculture, forestry, and fishery.*** Very small firms = less than 20 employees; in wholesale/retail/food/services, less than 5 employees.

All Business Places* Large Firms Small Firms Very Small Firms***

Figure 2: Number of Private Firms and Employees, by Industry, in 1999Source: METI SME Agency (2002a), p. 398, 402

of which:

# % of total # % of total # % of total # % of totalConstruction firms 555,847 100 475 0.1 555,372 99.9 526,027 94.6

employees 4,001,728 100 687,889 17.2 3,313,839 82.8 1,828,362 45.7Manufacturing firms 607,626 100 2,414 0.4 605,212 99.6 537,430 88.4

employees 11,062,690 100 4,189,681 37.9 6,873,009 62.1 1,904,318 17.2Wholesale firms 296,162 100 2,259 0.8 293,903 99.2 203,261 68.6

employees 3,734,037 100 1,120,608 30.0 2,613,429 70.0 362,210 9.7Retail firms 1,087,993 100 3,784 0.3 1,084,209 99.7 945,211 86.9

employees 6,123,121 100 2,236,490 36.5 3,886,631 63.5 934,781 15.3Food/Drinks firms 715,396 100 642 0.1 714,754 99.9 639,231 89.4

employees 2,871,213 100 770,822 26.8 2,100,391 73.2 795,190 27.7Services firms 1,185,708 100 3,881 0.3 1,181,827 99.7 1,001,806 84.5

employees 7,531,472 100 1,995,273 26.5 5,536,199 73.5 1,097,087 14.6Total* firms 4,851,104 100 14,340 0.3 4,836,764 99.7 4,228,781 87.2

employees 40,773,258 100 13,700,222 33.6 27,073,036 66.4 7,515,958 18.4

* Data include all registered firms (hojin) and self-employed, but exclude agriculture, forestry, and fishery.** Very small firms = less than 20 employees; in wholesale/retail/food/services: less than 5 employees.

All Firms* Large Firms Small Firms Very Small Firms**


might be referred to as “mom-and-pop drygoods stores” thatsell mostly cigarettes and instant noodle soups. There aremany social, political and economic reasons why these smallstores continue to exist in Japan.8

SMALL FIRMS AND THE SOCIAL CONTRACT IN JAPAN

Unlike in other countries, the division of “large” and“small” also divides Japan’s society. On the “large” side arethe “sarari-man,” the suited white-collar workers who com-mute to a downtown office building, and about whom somuch research has been conducted. Their children attendthe country’s best universities, in order to enjoy a similarlystable employment, and they receivehelp in finding a series of jobs afterretirement, in affiliated smaller com-panies.

On the “small” side, workers areusually not white collar; rather, theymay be engineers who do office work,but even then they usually wear theplant uniform. They may have at-tended a regional university, and theydo not expect lifetime employment. In fact, on average theyare laid off more than once in their career (Aoyama 2001).Because they usually have some transferable general knowl-edge – in engineering, chemistry, or another science – theyare often hired by another small firm. Japan’s current unem-ployment insurance system is geared towards these work-ers: after being laid off, Japanese workers receive a fairlygenerous 80% of their last salary, but only for six to twelvemonths, depending on age. During the postwar period ofrapid growth, many employees of small and medium-sizedfirms were able to find another job within half a year.

The very small firms with fewer than five employeesare again different. In many cases, employees are familymembers. When a very small firm faces hard times, the fam-ily has to rely on savings, relatives, or the local communityfor support. The savings rate in Japan continues to be high,even among the poorer part of the population, for exactlythis reason.

Japan’s government policies are concerned with smallfirms to some degree. To compensate for the disadvantagesin terms of export promotion policies and lack of lifetimeemployment, government and business over time establishedtwo mechanisms that were meant to tie at least the medium-sized firms into the logic of the covenant. The first was aseries of laws that protected small firms from exploitationby large firms and allowed cooperation through coopera-tives. The first such law was the “Small- and Medium-SizedEnterprise Law” of 1957; a series of other laws followed inthe 1960s. These laws offered preferential financing, subsi-dies and other support mechanisms for small firms. A newseries of small firm support laws passed in the late 1990sand early 2000s indicates that this policy continues.

A second stabilizing mechanism for small firms devel-oped through the so-called subcontractor (shitauke) system.Several authors have explained the economics of this par-ticular system, especially for the automobile industry (Smitka1991, McMillan 1990). The social relevance of the subcon-

tractor network was that it provided stability and certaintythrough exclusivity for the small suppliers. By having anexclusive tie-up with one automobile maker, the medium-or small-sized supplier benefited by receiving managementsupport and technological upgrades from the buyer, and bybeing supported (though often squeezed to minuscule mar-gins) in times of recession. The main benefit for the smallfirm was a predictable, stable series of incoming orders thatprovided safety and survival through business cycles. Thisstability allowed the firm’s employees to expect quasi-life-time employment.

While the automobile industry was special in the de-gree to which subcontractors had exclusive relationships with

large firms, the social logic held evenfor small firms that were non-exclu-sive suppliers. As long as they main-tained a relationship with a larger firm,the small firms could consider them-selves fairly safe. This explains why,in spite of numerous accounts of largefirms inappropriately squeezing prof-its of suppliers and not paying billswhen due, even as of 1998, 47.9% of

the small manufacturing firms (and as high as 76.4% of thosein the textile industry) opted to be in a subcontractor rela-tionship (Yabushita/Bushimata 2002).

For the very small firms, no such relationships exist.Very small manufacturing firms were often “4th tier” suppli-ers to small firms, who in turn supplied to firms who sup-plied to the large firm. The very small firms were usuallyeasily replaceable, and therefore not assured of any help intimes of trouble.

It is the substantial number of small and very small firmsthat are now in trouble. Of a postwar record 19,164 bank-ruptcies in 2002, 18,889 were of small- and medium-sizedfirms (METI SMEA 2002b). If economic reform were trulypushed towards market orientation, as Minister Takenakahas suggested, then even more firms should be allowed tofail, and the number of bankruptcies as well as unemploy-ment would skyrocket. In a way, unemployment may be thetelltale indicator of Japan’s reform progress: as long as itremains at or below 5%, one must suspect that artificial jobmaintenance is continuing, and that the market is not allowedto work on the allocation of resources. The main reason whythe government is continuing this intervention in the jobmarket through saving large, de facto bankrupt firms is thatthe country’s welfare system is ill-equipped to handle a largenumber of permanently unemployed Japanese.

Moreover, the way in which Japan’s government haschosen to provide direct support to small firms further un-dermines ongoing reforms. This is observable in industryafter industry, and is perhaps most visible in the bankingsector. Through three government banks for small firm fi-nance, the government is offering a special loan program tosmall firms at subsidized rates, which private banks claimdistort market rates.9 Small firms are also eligible for publicloan guarantees that allow them to borrow from private banks.These government loans and loan guarantees have beengreatly increased since the late 1990s, and then again inOctober 2002 with the aggressive move toward banking re-

The government is continuing tosave de facto bankrupt firmsbecause the welfare system

cannot handle a large number ofpermanently unemployed

Japanese.


Spring 2003

form. For very small firms, these loans and guarantees areas easy to get as welfare, but they save the borrower’s face.

To give just one hypothetical example, a 51 year oldtatami weaver who is unable to sell rice straw mats due tothe continuing recession, can opt to close down his store,receive unemployment for one year, and live off his lifetimesavings for perhaps four years. At age 56, he can either ap-ply for welfare and move in with his children (since welfarewill be insufficient), sell his house and become homeless, orcommit suicide (with the added “advantage” that his wifeand children may receive a more generous single motherwelfare program). Alternatively, if this person were to keephis store open, he could receive a series of government-spon-sored loans that would be largelyequivalent in function and even vol-ume to welfare.10

Thus, given the way in which thegovernment is offering support, abankrupt small firm faces incentivesto stay in business rather than closedown. While in terms of welfare pro-vision, offering subsidized loans tovery small firms may be to equivalent or better (in terms ofpersonal self esteem, etc.) than a monthly welfare check, forthe Japanese economy as a whole this direct governmentintervention distorts the market mechanism. As this occursin banking, it undermines reform efforts to clean up thebanks’ balance sheets by suppressing market interest ratesand thus bank profits; as it occurs in construction, it createsartificial demand at below-cost prices. For one industry af-ter another, we find that the very way in which Japan’s gov-ernment is supporting very small firms by offering “makework” schemes is undermining true reform.

THE SOCIAL CONTRACT AFTER THE BUBBLE

The social contract was not on people’s minds duringthe “bubble economy” of 1987-1991, when an easy mon-etary policy, a land price boom, and a stock market frenzycoincided to trigger speculative investments by almost allparts of society. Even when clear signs of a “bubble”economy became visible, hubris led politicians, bureaucrats,firms and households to believe that their system had madethem a world leader, and that therefore Japan’s land priceswould never collapse. Rules on pension fund investment werederegulated, and public welfare corporations joined in theinvestment frenzy, as did the postal bank’s life and pensioninsurance systems.

When the bubble burst, banks and large companies facedhuge amounts of bad loans. Private life insurance compa-nies came under great strain as they lost fortunes in the crash-ing stock market (and in the deflation of the late 1990s, whenfor several years interest rates were much lower than theinsurance payout premiums). Some life insurance compa-nies were closed down in the mid-1990s, spelling a socialdisaster: not only was there limited funding for social secu-rity to begin with, but with the stock market returning to1985 levels, Japan lost tremendous amounts of private andpublic social security funds.

Given these “bubble” losses, and the ongoing transition

to a post-industrialized and rapidly aging society, Japan’ssocial security system came under increasing pressure. First,as large firms caught up with Western technology and thenbegan to mature, they faced growth limits, making them un-able to hire more “lifetime employees.” Because lifetime em-ployment used to be coupled with seniority wages (i.e., in-creases in wages depending on tenure with the company),this system was predicated on continuing growth. To lowertheir costs, many large firms moved production abroad, thusreducing their domestic workforce and putting pressure ontheir suppliers. Second, with financial globalization and de-regulation, the financial system opened up. This meant thatJapanese firms faced increased costs of borrowing, and Japa-

nese banks lost their previous profitcushion (guaranteed through thespread between loan and deposit ratesunder interest regulation). Third, withtrade liberalization based on legal re-forms in the 1980s and 1990s, manyindustries faced more import compe-tition; while some industries were suc-cessful in keeping their markets

closed, others opened.11 Furthermore, over many years ofhigh economic growth, lifetime employment had becomealmost institutionalized through a series of court decisionsthat made it increasingly difficult for firms to lay off work-ers. While there were ways around the rules, during the re-cession of the 1990s large firms could not easily restructure.One large firm after another found itself in trouble, unableto launch a managerial turnaround given institutional con-straints. With an increasing number of large firms facingbankruptcy, large banks – fighting a bad loan problem – wereless and less able to bail out their clients.

A 2001 change by the Ministry of Labor on employ-ment rules made large-scale layoffs of certain non-perform-ing employees a possibility (previously, a demonstrated in-capability to perform a certain job was insufficient reason todismiss a worker; the employer was obligated to find theperson a different position within the company). However,after the 2001 change in rules, the politicians became evenmore active in intervening in corporate failures. Nearly ev-ery time a large firm faced bankruptcy, the government ap-parently felt that it was its responsibility to protect employ-ment. Thus, for example, while pushing large banks to cleanup their bad loans in 2002, the government asked these samebanks to bail out failing firms that happened to be large em-ployers and large buyers from small firms, such as the Daieidiscount chain or the Sogo Department Store. Later in thesame year, authorities agreed to purchase shares from banksto raise the banks’ equity ratios. Again, a reform measure –the cleanup of banks – was accompanied by a status quopreserving countermeasure.

Thus, good reforms were undermined because the gov-ernment had neglected to construct a meaningful public safetynet for employees. The concerns were gravest for the small-est firms that had the fewest resources to fall back on, andthus were hit the hardest. A conspicuous increase in povertyand homelessness made it increasingly apparent that Japan’sgovernment had defaulted on its responsibilities within thesocial contract. Most politicians, therefore, were keenly in-

Given the government’s offer ofsupport, a bankrupt small firm

faces incentives to stay inbusiness rather than close down.


terested in maintaining the official unemployment rate at the5% level, lest they be voted out of office or the rising unem-ployment lead to social unrest in the country.

The underlying motivation for this behavior is thatJapan’s social contract – with its implicit political obliga-tions and bureaucratic rigidities – is based on the pillars ofstability, certainty, and security, and therefore does not al-low a sharp increase in homelessness and other social suf-fering that would be the necessary result of truly market-oriented corporate restructuring. In a way, Japanese leadersmay not sufficiently believe in the market to promote truemarket-oriented reform. Thus, when Minister Takenaka be-gan to promote his reform program, many of the older mem-bers of the Liberal Democratic Party pushed for more com-pensating countermeasures that offered small firms somemeasure of protection from the harsh effects of these mar-ket-oriented reforms. Every protective move created newproblems to solve, such as the loan guarantees that made itmore difficult to close down small credit cooperatives thatwere effectively moribund. As a result, reforms had limitedeffects and required more “reforms” to deal with newly cre-ated issues. As a result, the “reforms” beginning in the 1990scharted a painful, winding path.

CONCLUSION: THE FIRST STEP

Many observers agree that Japan needs to fundamen-tally change its industrial structure, as it did after the “oilshock” in the 1970s, if the economy is to adjust to Japan’snew status as a post-industrial society with an emphasis onservice industries. Even those who argue that some of Japan’sfeatures may be preferable to those of more market-orientedeconomies have to agree that a weeding out of the old dino-saurs – large and small – can only be beneficial. Accord-ingly, Japan’s prime minister has appointed a team that isdiligently working on the reform of banks, companies, andrules. Yet the overall economy has been resistant to change,because with every reform measure comes a counterbalanc-ing quasi-welfare measure that impedes true reform.

There are several political and societal reasons for thisresistance to change, but the biggest systemic reason, thispaper has argued, is the lack of a welfare system sufficientlyfunded to absorb a high rate of structural (long-term) unem-ployment that corporate and industrial reform will necessar-ily engender. If Japan were to tackle full reform of its eco-nomic structure, unemployment could easily double. Already,at an official level of 5%, Japan’s incidence of poverty,homelessness, and suicide has skyrocketed.12 Many politi-cians therefore push hard to protect small firms as well assome large firms that have either many employees or manysmall-firm suppliers.

The lack of a full-fledged welfare system also depressesconsumption. As of 2002, the average household had sav-ings of ¥500 million, which is estimated as lasting for aboutfour years for an extremely frugal family of three.13 Wivesare worried that their husbands may suddenly be laid off,and therefore suppress consumption to save for this eventu-ality. A reliable and adequate welfare system would allevi-ate many of these fears. The critical role of social securityand Japan’s social contract is overlooked by many in the US

who have pushed for macroeconomic policies that aim topull Japan out of the liquidity trap (Krugman 2002), or forinflation targeting to fight deflation (Posen 1998). These pro-posals may be based on a misreading of what market re-forms have actually accomplished in Japan.

A first basic step toward reform in Japan is to introducea social security system capable of cushioning the negativesocial effects of reform. How exactly this system should befinanced is a subject that warrants a separate paper. What isnecessary at this point is the government’s promise and com-mitment to provide welfare support – which could be fundedthrough future revenues. In fact, this commitment alreadyexists, as is evident in the government’s generously subsi-dized loan programs for very small firms, the government’sparticipation in small firm finance through public banks, andthe support offered to banks that are willing to bail out defacto bankrupt firms.

However, one has to take issue with this “big govern-ment in the market ” approach. Welfare payments, as laidout in the social contract, are best arranged through a trans-fer of wealth from the rich to the needy, e.g., through pro-gressive taxes. The Japanese government, instead, is inter-vening in the market through low interest rate loan programs,loan guarantees and other such means. The upside of thisapproach is that the recipient does not have to visit the wel-fare office, but can go to a bank and continue to run his busi-ness, however inefficiently. He thus saves face, somethingthat continues to be very important in Japanese society. Theheavy downside of this approach is price distortion in themarket. If Japan really wants to move towards more market-oriented measures, the government has to consider a moredirect and transparent incomes policy.

I am very grateful to Charles O’Reilly III, Patricia Hagan-Kuwayama, Hiroshi Fujiki, Peter Gourevitch, Takeo Hoshi,Hugh Patrick, and two anonymous reviewers for extensiveand extremely insightful comments on earlier drafts.

REFERENCES

Aoyama, Kazumasa, Kaimei Chûsho kigyô ron: Chûsho kigyômondai e no tamenteki approochi (Understanding Small- andMedium-Sized Firms: A Multi-Aspect Approach to the SMEProblem) (Tokyo: Dôyûkan, 2001).

Johnson, Chalmers, MITI and the Japanese Miracle – TheGrowth of Industrial Policy, 1925-1975 (Stanford: StanfordUniversity Press, 1982).

Krugman, Paul, Kyôkô no wana: Naze seisaku o machigae-tsuzukeru no ka? (Japan’s Trap – The Trap of Crisis: Why


Spring 2003

Policy Mistakes are Continuing) (Tokyo: Chûô Kôron-sha,2002).

Locke, John, Two Treatises on Civil Government (1690).

McMillan, John, “Managing Suppliers: Incentive Systemsin Japanese and U.S. Industry,” California ManagementReview, Vol. 32 No. 4 (Summer 1990), pp. 38-55.

METI SME Agency (Ministry of Economy, Trade and In-dustry, Small- and Medium-Sized Enterprise Agency), Heisei14nendo-han Chûsho kigyô shisaku sôran (Overview overSME Policies) (Tokyo: Chûsho kigyô sôgô kenkyû kikô:2002).

METI SME Agency (Ministry of Economy, Trade and In-dustry, Small- and Medium-Sized Enterprise Agency),Chûsho kigyô hakusho 14nen (Small and Medium-SizedFirm White Paper 2002).

Nakamura, Takafusa, The Postwar Japanese Economy (To-kyo: University of Tokyo Press, 1981).

Olson, Mancur, The Rise and Decline of Nations: EconomicGrowth, Stagflation, and Social Rigidities (New Haven: YaleUniversity Press, 1982).

Patrick, Hugh T. and Thomas P. Rohlen, “Small-Scale Fam-ily Enterprises,” in Kozo Yamamura and Yasukichi Yasuba(eds.), The Political Economy of Japan, Vol.1: The Domes-tic Transformation (Stanford: Stanford University Press,1987), pp. 331-384.

Posen, Adam, Restoring Japan’s Economic Growth (Wash-ington DC: Institute of International Economics, 1998).

Rousseau, John-Jacques, Du Contrat Social (1762).

Schaede, Ulrike, Cooperative Capitalism: Self-Regulation,Trade Associations, and the Anti-Monopoly Law in Japan(Oxford: Oxford University Press, 2000).

Schaede, Ulrike, “Industry Rules: From Deregulation to Self-Regulation,” in Schaede, Ulrike and William Grimes (eds.),Japan’s Managed Globalization: Adapting to the 21st Century(Armonk: M.E. Sharpe, 2003), pp. 191-214.

Schaede, Ulrike, “Does Japan Need Specialized Small FirmBanks?”, Working Paper, University of California, San Diego(forthcoming).

Smitka, Michael, Competitive Ties: Subcontracting in theJapanese Automotive Industry (New York: ColumbiaUniversity Press, 1991).

Yabushita Shiro and T. Bushimata, Chûsho kigyo kinyunyûmon (Introduction to Small Business Finance) (Tokyo:Tôyô Keizai shinpô-sha, 2002).

ENDNOTES

1 Another example in this category was the decision to re-form the country’s deposit insurance scheme and correct bankincentives, by limiting this insurance to ¥10 million (roughly$85,000) per account. After the reform was pushed throughthe Diet (parliament), however, the actual implementationwas delayed for years, allegedly to give small banks time torestructure so as to avoid a run on their deposits. This delayupheld the moral hazard inherent in the entire banking sys-tem through deposit insurance.2 In wholesale, the new limits are ¥100 million or 100 em-ployees, in services they are ¥50 million or 100 employees,and for retail outlets the limits are ¥50 million or 50 employ-ees (Bushimata and Yabushita 2002).3 Literature on the very small firms is scarce. A remarkableexception is Patrick and Rohlen (1987), a paper that hasshaped most of the established views on the topic.4 Aoyama 2001, p. 37.5 Aoyama 2001.6 Aoyama 2001; at that time, one Euro was very close invalue to one dollar.7 According to the US Department of Treasury, IRS, Statis-tics of Income Bulletin, Spring 1996, Table 21; and Yabushitaand Bushimata 2002, citing the US Small Business Admin-istration.8 One important reason is that old people who own a houseon a busy street cannot afford not to keep running a “drygoodsstore” because the welfare payments they receive are insuf-ficient. The economic logic becomes clear once one consid-ers the system of “henpin,” or “return of unsold goods.” Intheir competition for shelf space, manufacturers allow smallretailers to return unsold items at no cost. Thus, a familywith a good traffic location and little opportunity cost of timecan earn money by selling little daily-use items, as they facelittle inventory costs.9 The three banks are the Chûsho kigyô kinyû kôko (JapanFinance Corporation for Small Business), the Kokumin kinyûkôko (National Life Finance Corporation), and the ShôkoChûkin. See Schaede (forthcoming) for details.10 Interviews with various officials and individuals, Tokyo,Winter 2003.11 As a step-by-step reduction of entry permits through de-regulation potentially exposed many industries to new com-petition through new entry and imports, some industrieschose to cooperate through their trade associations in set-ting up new, self-designed industry rules to block this newentry. For example, this could be achieved through refusingto deal with companies that were not members of the tradeassociation, and then creating new rules once they joinedthe association. See Schaede (2000, 2003) on partial marketopening with deregulation, and self-regulation through tradeassociations.12 According to official Ministry of Health, Labor and Wel-fare data, there were roughly 31,000 suicides in Japan inboth 2000 and 2001, and 32,000 in 2002. This is more than80 suicides a day.13 Interview with a researcher at Japan Research Institute,Tokyo, Winter 2003.

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