Insider Lending and Economic Transition: The Structure, Function, and Performance Impact of Finance Companies in Chinese Business Groups

Abstract

During the 1980s, China experienced dramatic real growth without the benefit of a well-developed financial system. China's experience during that decade provides an interesting contrast to evidence that real growth is strongly correlated with the development of an economy's formal financial system. Also during the 1980s, business groups were developing among Chinese firms. Many business groups, almost immediately after their formation, established finance companies, specialized firms that collected and redistributed funds within the group and also obtained funds through state banks on behalf of member firms. As such, the finance companies engaged in a type of "insider lending" that economic historians argue has aided firms in overcoming the challenges associated with poorly-developed formal financial markets in other developing economies. I examine the emergence, structure, and performance impact of insider lending arrangements in Chinese business groups using data on China's 40 largest business groups and their 535 member firms in 1988 and 1990. The analyses reveal that the presence and predominance of insider lending arrangements in the business groups positively affect the financial performance (profitability) and productivity (output per worker) of firms, particularly where markets have been slow to develop.