'Informal' Entrepreneurship is the key to China's success (page 1 of 3)

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"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 in April, 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.