China should take advantage of Hong Kong’s legal system in building financial markets
Hong Kong’s common law system endows China with a most important strategic competitive advantage in reforming and developing its financial system and finance industry.
Common law practiced here is based on an entirely different tradition from the civil law on the Chinese mainland, and is more conducive to fostering robust financial market developments. It could provide China with a unique opportunity to strategically experiment with opening up its financial markets internationally on an alternative platform.
Already, we have seen China list the shares of its companies, float state and private bonds, and liberalise its currency. It should take full advantage of the situation that within its national boundaries it has a Special Administrative Region that through the accident of history has a legal system different from its own (and also from Macao’s, which has a civil law system).
The common law system was developed in England in the 12th and 13th centuries, while the civil law system emerged from France around the same time. They have had very different economic consequences for the societies that adopted them, especially for financial market development.
A central issue in the development of financial markets is the legal protection of investors, especially those from outside, because limiting their expropriation by corporate insiders promotes financial transactions among strangers. Financial market development thrives under such circumstances.
Common law countries have offered more protection to shareholders and creditors than civil law countries based on the French tradition. Better investor protection has been associated with improved financial development, better access to finance, and higher ownership dispersion.
Moreover, civil law is associated with a higher degree of government ownership and regulation, which has adverse impacts on markets. Relative to common law countries, civil law countries have more intrusive business and labour regulations, and higher state ownership of banks and the media.
Civil law countries also generally have more legal formalism, lower judicial tenure, and sharply lower constitutional acceptance of case law – in contrast to common law countries, which are associated with more secure property rights and better contract enforcement.
There is also less flexibility in contract enforcement in civil law, which is more encumbered by social concerns such as protection of workers. Greater contractual flexibility promotes financial development.
All of these contrasting features make financial and economic affairs in common law countries more efficient than in civil law countries, at least under non-turbulent and peaceful times. The conclusion is that common law countries are more protective of private property than those adhering to the French tradition. This is vitally important for financial market development.
Innovation is particularly sensitive to private property rights protection. The common law framework and institutions provide a better balance of incentives to reward innovators and the efficient spread of their benefits for users through the market.
Data on the ratio of stock market capitalisation to GDP is very telling. The ratios in common law countries were much higher from 1800-1980 than those civil law countries (see Figure 1).
Governments in the two legal systems also differ in how they respond to new needs. Civil law countries favour nationalization policies and direct state control, which tend to expand the scope of government control. In common law countries, there is more litigation and market-supporting regulation.
The differences can be seen when the market system gets into trouble. China, for example, attempted to prop up stock prices this summer with aggressive state mandates. During the Great Depression, Britain, Canada and the US introduced securities regulation and deposit insurance to rehabilitate and support markets. They ultimately strengthened shareholder rights.
It is interesting to note that the Qianhai New District in Shenzhen aims to replicate the common law system to promote financial market development. Time will tell whether this experiment will succeed. Hong Kong’s real competition today is from London and New York; perhaps someday Shenzhen will become a worthy competitor if the Qianhai experiment works.
Richard Wong Yue-chim is Philip Wong Kennedy Wong Professor in Political Economy at the University of Hong Kong