In a new article. I investigate how two financial markets of trillions of dollars each have developed extralegally in the past two decades, creating risks of regulatory enforcement actions and contract defaults. More specifically, I examine (1) how Chinese internet companies from Sina to Alibaba have adopted the structure of a variable interest entity (“VIE”) both to circumvent the Chinese government’s ban on foreign capital in high-tech industries and to get listed on overseas stock markets, and (2) how Chinese entities and foreign investors contract out of China’s stringent regulations on the issuance of international bonds, focusing on one of the most notable extralegal forms called keepwell deeds (“KWDs”). Onshore Chinese companies use KWDs to provide credit support to their overseas subsidiaries, through which the former issue international bonds indirectly.
When investors purchase shares or bonds of a corporation managed by somebody they do not know, there are two risks at play: that managers may run away with the investors’ money and that the government may expropriate the investment. The first risk can be mitigated by legal institutions that adjudicate disputes and enforce contracts, and their effectiveness, at least according to the conventional wisdom, helps determine the development of financial markets. State backing is essential to contemporary financial markets because it can enforce “the legal code of capital,” as Professor Katharina Pistor has recently argued.
But how can a state be prevented from expropriating investments, the second risk noted above? The conventional answer is again the law, which determines what the state can and cannot do. Independent courts can rule on the basis law against the state. But where do the law and courts come from? How does a state behave in their absence? Can a state act in opposition to its own laws?
In my article, I examine how politics work in the absence of law, or even in opposition to legal barriers, to support financial development. The state and law are, of course, different things. The state itself is hardly bound by law in many developing countries or transnational contexts in which there are often no independent courts or effective enforcement of judicial decisions to hold the state accountable.
For developing countries, the barrier to financial development is often not the absence of law, but rather the presence of bad laws in the form of prohibitions and restrictions on financial investment. Finding a way to handle such bad laws poses a challenge to a state interested in financial development. China serves as a good example. A fundamental dilemma for the Chinese party-state is the tension between two goals: control and development. To achieve control, it imposes restrictions on foreign capital and investment. To achieve development, it requires access to credit and must attract foreign capital. Within China’s domestic politics, separate factions are in charge of these two conflicting goals. When there is a stalemate between the factions, which regularly occurs, the imposition of regulatory barriers or an outright ban is the default position. In response, the liberal faction often supports innovative ways to circumvent those barriers. It is often only after a market practice has proved to be successful in promoting development without endangering the party-state’s control that the practice is fully recognized and sanctioned by law.
I call China’s approach “governing by extralegality,” which serves the party-state’s interests by maintaining a tricky balance between development and control. When there is strong demand for development, the party-state can send signals to assure investors of the security of their (sometimes extralegal) contract arrangements. The market often follows such political signals. For the party-state, such extralegality leaves room for control, as it can take over via enforcement against extralegal practices. It is for this reason that the conservative faction is often willing to acquiesce to development-oriented practices.
The extralegality of VIEs and KWDs results from the tension between development and control within China’s domestic politics. With respect to VIEs, the party-state recognizes the importance of the internet to China’s development and has been persuaded that access to international financial markets is essential to the development of the country’s internet industry. At the same time, however, it worries that China’s internet, which provides information and news services to the public, might become subject to foreign control or influence. That is why it has maintained an outright ban on foreign investment in China’s internet industry while allowing Chinese internet companies to list overseas through VIEs.
A similar rationale applies to overseas debt. China successfully weathered the 2008 financial crisis by implementing an RMB 4 trillion ($620 billion) stimulus package but has been combating a real estate bubble and mounting debt ever since, partly because most of the stimulus money flowed into real estate-related sectors. The Chinese government needs to contain the bubble without bursting it. To do so, it has limited real estate-related enterprises’ access to credit in the domestic market. At the same time, to avoid bankruptcies and potentially triggering a financial crisis, it has allowed these enterprises access to the international credit market through extralegal contract arrangements that circumvent China’s restrictions on foreign debt and cross-border guarantees.
In the VIE structure, foreign investors do not hold equity shares in the Chinese company concerned, but instead hold claims to control and to financial gains through a multi-layered contractual arrangement. For the purpose of issuing international bonds, Chinese onshore parent companies designed KWDs to circumvent Chinese regulations on cross-border guarantees. Nevertheless, the market treated KWDs as having the same binding effect as guarantees on their providers before a significant default occurred in 2020. The problem is that neither contracts under the VIE structure nor KWDs are enforceable in Chinese courts.
The Chinese government has a profound interest in suspending the enforcement of bad laws but has yet to formulate new laws to support new financial markets. Even when state and law are in conflict, as they are in the Chinese case, a state’s commitment to not enforcing the law against extralegal investments is credible to the degree that the state cares about its reputation and access to global financial market. Like the market for sovereign bonds, in extralegal markets created by the state and market participants, the political elites whose power and interests rely on the state’s interests and access to global financial markets, can also hold the state to its extralegal commitment not to expropriate private investments.
The challenge is that the reputation mechanism works well in a market where participants know one another and engage in long-term, repeat transactions, but it does not work well among strangers engaging in one-off transactions. The transnational market of corporate debts and capital appears to be impersonal.
How impersonal? The vast increase in the concentration and centralization of international financial markets in the past few decades has meant that an ever-smaller circle of systemically important and politically powerful private banks and financial institutions in the West can hold not only sovereign states but also firms and households accountable. Moreover, financial intermediaries define codes of behavior and facilitate the flow of information. The concentration of foreign capital in certain industries also helps to form industry-specific communities.
More important, state participation, even in extralegal contract relations, provides some stability and predictability to extralegal private contract relationships. The state, as the representative of the interests and reputation of all market participants under its jurisdiction, also maintains order in the extralegal financial markets it creates with other market participants. Such state participation, together with the more conventional private reputation mechanism, mitigates the risk of contract defaults in the transnational market of corporate debt and capital. The state has a collective interest in maintaining its reputation for respecting and maintaining extralegal arrangements known to be useful for the state. There are of course risks to trust based on a state’s observed incentives, but they are manageable risks in ordinary times.
In differentiating between the state from law and recognizing state reputation as an alternative to legal protections for supporting extralegal financial development, my article challenges both the “bottom-up” and “state-law” accounts of Chinese capitalism. Professors Katherina Pistor and Chenggang Xu noted China’s use of non-legal measures in boosting its stock market; Professor Pistor further theorizes that China relies on its cadre management system to govern its financial system. Yet, as Professor Pistor wrote in 2013, “it remains to be seen how effectively it can be employed for governing China’s exposure to global finance.” My article fills the gap by focusing on China’s exposure to global finance and develops a more systemic theory explaining China’s finance without law.
This post comes to us from Professor Shitong Qiao at Duke University School of Law. It is based on his recent article, “Finance Without Law: The Case of China,” forthcoming in the Harvard International Law Journal and available here.