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The Effectiveness of the Law, Financial Development, and Economic Growth in an Economy of Financial Depression: Evidence from China

Enhancing the legal system may hinder the development of some aspects of the financial sector in an economy characterized by financial repression. Using Chinese provincial data in the 1990s, we find that an enhanced legal system suppresses private investment, increases the private share of bank credit and bank competition, and has no effect on financial depth. We interpret those findings as evidence showing the existence of the leakage effect that moves financial resources from the privileged state sector to the rationed private sector. In addition, we find that an enhanced legal system does not have a significant effect on the average growth rate. We conclude that the smooth functioning of the legal system requires other institutions to complement it.

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Susan Feng Lu
Yang Yao
Publication Date
August, 2003