China is turning conventional business wisdom on its head.


Business scholars in recent years have argued that sound financial and legal systems are vital to economic growth. China lacks all of the above, but the country’s economy is growing like gangbusters – averaging 8.35% expansion for most of the 1990s.


“There’s this paradox that China has been doing extremely well,” said Wharton finance professor Franklin Allen, who has studied the issue with Jun Qian, a former Wharton Ph.D. student and now a professor at Boston College, and Meijun Qian, a Boston College graduate student. At a conference on “The Future of Chinese Management” held April 22, 2002, at the Wharton West campus in San Francisco, Allen and his colleagues proposed an answer to the Chinese economic puzzle: The key to the country’s success lies in its fast-growing “informal” sector.


Allen, Qian and Qian define this sector as all firms not controlled by the government or publicly traded. They say this swath of the economy relies on factors such as cultural norms and economic competition to promote good corporate governance, and depends more on bonds of trust and reputation for financing rather than traditional Western sources of capital.


“It’s not so much the banks and the stock market that are important, it’s the informal sector that’s driving China’s growth,” Allen told the audience. What’s more, he said, imposing Western models of economic growth without understanding their effect on the informal sector could be harmful to China and other developing nations.


Allen and his colleagues found compelling evidence to support their case. While state-owned and publicly traded companies controlled by the government grew at an annual rate of 4.65% from 1995 to 1999, the informal sector sped ahead at an annual rate of 19%. During that same period, the informal sector employed an average of 67.5% of all non-agricultural workers in the country.


The informal sector is made up of two types of firms. The first kind is what may be called a quasi-state-owned firm, which involves joint ownership between the government and local communities or institutions. The second is a privately-owned firm, which can be controlled by Chinese citizens or investors from Taiwan, Hong Kong or other countries.


To convey the way the informal sector works, Allen pointed to Chinese students at Wharton who have managed to succeed as entrepreneurs through unconventional paths. One former Wharton student got her start as a clothing industry tycoon not by seeking credit from banks or venture capitalists, but because of her connections at a state-run clothing firm. By capitalizing on relationships with other business partners and workers, she managed to create a company with five factories in a scant five years. “They don’t really need to borrow,” Allen said. “It’s a form of trade credit. It’s all done on reputation.”


This method of “informal” entrepreneurship isn’t surprising given the sorry state of the Chinese financial and legal system, at least from a businessperson’s point of view. Allen and colleagues compared China with other countries when it comes to issues such as shareholders’ rights, creditors’ rights, corruption within the legal system and regulatory hurdles. China scored poorly. For example, its commercial banks face much higher levels of regulation than do banks in other countries. As for its legal system, William Overholt, senior fellow at the Harvard University Asia Center and another speaker at the conference, noted that only recently have judges in Shanghai been required to study law.


But looking solely at China’s financial and legal institutions can blind observers trying to explain the country’s economic growth, Allen argued. It’s a perspective, he said, stemming from an academic bias that favors the U.S. “This is a very U.S.-oriented (view) of the world,” he said. Flaws in the studies linking legal and financial systems and growth include giving equal weight to countries as large as India and as small as Ecuador and consistently excluding the world’s biggest country, China.


To understand China’s success, Allen and his colleagues consider other theories. One of the more surprising comes from research on medieval traders. Merchants in the 11th century were able to overcome the lack of a legal system by creating institutions based on reputation, implicit contractual relations and coalitions, Allen, Qian and Qian note. Similar developments may be underway in China, they suggest.


Common values embodied in Confucianism also may be providing a structure for China’s turbocharged informal economy. In a paper completed prior to the conference, Allen, Qian and Qian write: “(Confucianism) clearly defines family and social orders, which are very different from the western beliefs on how legal codes should be formulated. Although this set of beliefs has never been formally adopted into the law, it has profound impact on the Chinese people and will continue to do so in the future.”


Besides cultural values, competition itself may promote sound corporate governance in China. Allen pointed to Japan as a case in point. In industries subject to international competition – such as automobiles and consumer electronics – Japanese companies are world leaders, he said, but the protected construction industry is inefficient. In the same fashion, Chinese business leaders in the informal sector, busy trying to win in the market, may run their firms well without threat of an investor-led takeover or government monitoring.


When it comes to scraping together capital, “self-financing” is critical in the informal sector, Allen, Qian and Qian found. Rather than turn to banks or various levels of government, entrepreneurs and heads of jointly-owned firms tend to raise money through local communities and investors from abroad, and through informal borrowing from firms and institutions.


Although Chinese business leaders in the informal sector may have developed unconventional ways of doing business since Deng Xiaoping launched market reforms in 1979, a major factor behind their current success is a capitalistic urge well known in the West, Jun Qian told the conference audience. “People have the right to make their private profits now,” he said. “That kind of incentive and drive will dominate at the end of the day.”


His point is illustrated by the way Chinese icons have changed in the past several decades. In 1963, chairman Mao Zedong asked the nation to “Learn from Lei Feng,” a soldier said to have devoted all his spare time to volunteer work. A Chinese government web site continues to pay homage to Lei Feng. Now, though, it is China’s newly-minted millionaires who command respect, Qian said.


Meanwhile, the Chinese government is taking steps to make life easier for entrepreneurs in both the formal and informal sectors. That was a central message from Peking University professor Weiying Zhang, another conference presenter. “Twenty-two years of reform has transformed the Chinese economy from a planned economy to a regulated economy,” said Zhang, who is executive associate dean of Peking University’s Guanghua School of Management. The next step, Zhang said, is moving to a “market” economy.


But thousands of regulations still govern businesses, many of which aren’t always published. In addition, the rules change frequently and the mandates of various government agencies are not coordinated. “Many regulatory laws are conflicting, because different governments make different rules,” Zhang said, adding, however, that some relief is on the way. He pointed to a central government office whose mission is to reform the administrative approval process. The office helped slash the number of required approvals at the State Economic and Trade Commission from 121 to 58, and some regional governments have made similar progress.


Each stamp of approval a business avoids means one less opportunity for a corrupt official to demand a bribe. And Zhang pointed to another development suggesting politics is playing a smaller role in business affairs: Multinational companies such as Sony have been moving their headquarters from national capital Beijing to Shanghai, the country’s economic dynamo. “That is a very, very important signal,” Zhang said. “That means Beijing is less and less important.”


Less important, perhaps, but China’s government still can make life difficult for entrepreneurs. So said conference speaker Hong-Tai Chou, CEO of Incubenet, an organization of angel investors with business connections in China, Hong Kong, Taiwan and Singapore. Chou sparked laughter with the results of his informal survey about how “free” China’s markets are. “They are free…if you don’t get caught,” Chou quoted a Shanghai friend saying. Another friend in Taiwan said the answer depends “on whom you know and how you motivate them.”


Silicon Valley entrepreneurs of Asian descent who are thinking about returning to China had yet another answer, according to Chou. The markets will be free, they say, once China joins the World Trade Organization. China officially became a member of the WTO last year, and has agreed to undertake additional economic reforms.


Taiwan-born Chou, who sold his firm Omniscience to Oracle before he founded Incubenet, concluded that China’s economy is flexible and rewarding for the adventurous. But he added that it is a challenging environment for both multinationals and people of Chinese descent returning from overseas. Echoing a point of Zhang’s, Chou said it is difficult to keep up with rapidly changing laws and regulations. China also lacks experienced managers, Chou said, and it can be confusing for overseas investors to understand the accounting methods used by Chinese firms. To top it off, investors often struggle to take money made in China out of the country. “There are lots of ways,” Chou joked. “But most are not very legal.”


Anthony Neoh, chief adviser to the China Securities Regulatory Commission and another speaker at the conference, asked Chou if the obstacles he (Chou) cited are stopping him from investing in China. “Not stopping me, just delaying me,” Chou answered. “We’re still learning.”


Understanding more about China’s economy is critical, argued Allen, Qian and Qian. In particular, Allen and his colleagues say more information must be gathered about the informal sector at the heart of China’s growth. To ignore that part of the economy while pushing to make China look like the developed world risks killing the goose laying the country’s golden eggs, Allen told the conference audience. Care must be taken not to harm that sector “by trying to go for the traditional kinds of reforms.”


He added that China’s informal sector may provide lessons for other developing and even developed countries as they seek to spur economic expansion.


Another important question is how China’s economic growth relates to the country’s political system, which remains largely authoritarian. On the one hand, the Chinese Communist Party’s firm hand is contributing to the burgeoning informal sector, Qian suggested. Given a poor court system for settling business disputes, one could imagine gangs arising to enforce deals. But through its very harsh criminal penalties, the government deters organized crime, Qian said.


Yet Qian also noted that the prosperity created by China’s growth could help trigger the downfall of Communist Party rule. In other words, economic success may breed more democratic yearnings. “When people have more money to spend,” he said, “they care about other parts of their life as well.”