Institutional Quality, Financial Friction, and Sustained Economic Growth: The Case of China

ABSTRACT

Can an economy achieve sustained growth without significant improvement in institutional quality? What are the differences in the driving forces of short- and long-term growth? This paper tries to answer these questions in a simple framework with financial friction. Our theoretical model shows that, at the early stage, institutional quality does not play a critical role because the return differential is too high to overcome the friction of low institutional quality. However, as the economy grows, institutional quality eventually becomes the most important factor affecting economic growth. Thus building high-quality institutions plays a critical role in long-term economic growth.

KEYWORDS:

• Economic growth
• financial friction
• institutional quality

JEL CLASSIFICATION:

• E02
• O11
• G20

Notes

1. Rodrik (2014) defines consistent growth of at least 5% for more than 30 years as a “growth miracle”; by this measure, the number of countries (out of 214) that qualify is less than 20. Most countries cannot sustain such high-level growth for long periods. Of these 20 countries, only three experienced such growth before 1950: Australia, New Zealand (two Western countries that benefited from an immigration wave due to nineteenth-century expansion), and Venezuela (an oil boom in the first half of the twentieth century). The 17 countries with a growth miracle after 1950 can be divided into three types. First, some western countries with traditional Europe cultural, including Italy and Greece, benefited not only from the reconstruction of Europe after World War II but also from European integration. The second type consists of countries such as Saudi Arabia, Iraq, and Botswana that have reaped the benefits of continued prosperity from their natural resources (oil and diamonds). China is in the third category: “Asian tiger” economies in East and Southeast Asia, which also includes Japan, Korea, and Malaysia.

2. In a relationship-based society, information is personal, nonfluid, and nontransferable; contracts are invisible, personalized, and not standardized. In this kind of society, transactions have low fixed costs and increasing marginal costs. Thus, this structure is suitable only at early stages of economic growth, when market divisions are not fully developed, and both the number of market trading agents and the size of the information set are not large. In a rule-based social structure, information is impersonal, fluid, and transferable; contracts are visible, nonpersonalized, and standardized. Transactions have high fixed costs and low marginal costs, making it more suitable for a society with a large number of trading agents and a large information set.

3. China’s annual economic growth slowed from more than 10% to less than 7%.

4. The assumption is not in line with the reality of China, but it can simplify the calculation, and help us focus on the analysis of financial frictions and institutional quality.

5. Although some loans from state-owned banks to state-owned enterprises result in bad debts, SOEs and state-owned banks are vertically integrated, so there is no liability for them. Borrowing and lending between them is simply a matter of accounting, rather than a contractual situation with much greater economic implications.

6. Buera and Shin (2013) calibrated $v$ and $\eta$ based on labor force proportion of the top 10% of enterprises in the United States by scale and the share of the overall population made up of the top 5% income earners. Buera and Shin claim that this does not affect the use of these two parameters for transition countries, including China.

7. The cumulative distribution function of entrepreneurial talent at private enterprises follows the Pareto distribution: $M(e)=1-e^{-\eta }$, with $\eta =4.17$. Entrepreneurial talent is divided into 20 values, where $M(e_{19})=0.99$, $M(e_{20})=0.995$, and the remaining 18 values are uniformly distributed between $M(e_1)=0.8$ and $M(e_{18})=0.98$.

8. The relationship between the external finance rate and $\lambda$ is given by $\lambda$= 1/(1 – external finance rate).

Additional information

Funding

This work was supported by the Tianjin “131” Innovative Talent Team Project(2018) “Institutional Innovation and Regional Economic Growth” [201822]; Nankai University 100 Youth Leaders (Team) Training Program “Institution, Finance and Economic Growth” [63174018].