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

Abstract

In an economy characterized by financial repression, enhancing the legal system may hinder the development of some aspects of the financial sector, especially informal arrangements aiming at circumventing the repression. Using Chinese provincial data in the 1990s, we find that enhanced legal system suppresses private investment and has no effect on financial depth although it increases the private share of bank credits and bank competition. We interpret these 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 enhanced legal system does not have a significant effect on the average GDP growth rate. We conclude that the smooth functioning of the legal system requires other institutions to complement.

Keywords: legal system, financial development, financial repression, economic growth