(This essay was published in Hong Kong Economic Journal on 30 September 2015.)
On 20 September 2015, at a symposium on “Hong Kong’s Role in China’s Development Strategy” organized by the Chinese Association of Hong Kong and Macau Studies, I made the observation that the common law system of the Special Administrative Region endows China with a most important strategic competitive advantage in reforming and developing its financial system and finance industry.
Common law practiced in Hong Kong is based on an entirely different tradition from the civil law in the Mainland, and is more conducive to fostering robust financial market developments. Once you have one legal system, you cannot change it to another one without great difficulty; as far as I know, it has not actually happened before although some convergence between the two systems has taken place among the industrialized countries.
Hong Kong’s common law system provides China with a unique opportunity to strategically experiment with opening up its financial markets internationally on an alternative platform. Already China has listed shares of its companies, floated state and private bonds, and liberalized its currency. China should take full advantage of the situation that within its national boundaries it has a Special Administrative Region, which through the accident of history has a legal system that is different from its own. Macao, by contrast, is on the civil law system it inherited from Portuguese rule.
The common law system was developed indigenously in England in the 12th and 13th centuries, when trials by jury were introduced. The civil law system was developed in France around the same time, but was based on Roman law, especially Justinian law, which was preserved through the efforts of the Catholic Church during the Medieval Ages after the collapse of the Western Roman Empire.
French civil law took a huge stride forward under Napoleon who codified French legal codes.
The Revolutionary Wars helped spread Napoleonic codes throughout continental Europe. It became the basis for the later German and Scandinavian legal codes. These became known as the continental legal tradition.
During the age of imperialism, the common law and civil law systems were both exported to the colonies and imposed on them. Other nations voluntarily adopted one of these two law systems. In the early 20th century, China adopted the German legal code in its efforts to foster economic growth and international trade. The German Civil Code of 1900 was also the principal influence on the legal codes of Japan. Russia adopted French civil law voluntarily, which was the foundation for the socialist legal codes in the Soviet Union, and has since reverted back to French civil law after the collapse of the Soviet Union.
The differing origins of common law and civil law have resulted in very different consequences for the development of the economies and economic life in the societies that adopted them, especially for financial market development.
A central issue in the development of financial markets is the legal protection of investors. Legal rules governing investor protection are coded for many countries using national commercial laws, primarily corporate and bankruptcy laws. These include coded rules for the protection of outside shareholders and the protection of outside senior creditors.
Legal protection of outside investors is especially important because by limiting the extent of expropriation of such investors by corporate insiders, it promotes financial transactions among strangers. Financial market development thrives under such circumstances.
Legal rules protecting shareholders and creditors vary systematically among legal traditions, with common law countries (originating in English law) being more protective than civil law countries, particularly French civil law countries (originating in Roman law). The legal origins of commercial laws as an instrument for legal protection of investors are a strong predictor of financial market development. Civil law is generally associated with lower shareholder and creditor protection.
Civil law is also associated with a higher degree of government ownership and regulation of markets than common law, with adverse impacts on markets. Relative to common law countries, French legal origin countries have more intrusive business and labor regulations, and higher state ownership of banks and the media.
Compared to common law countries, civil law countries generally have more legal formalism, lower judicial tenure, and sharply lower constitutional acceptance of case law. The characteristics of the judiciary, therefore, vary by legal system. Common law is associated with less formalism of judicial procedures and greater judicial independence than civil law, which are in turn associated with more secure property rights and better contract enforcement.
Compared to French civil law, common law is associated with better investor protection, which in turn is associated with improved financial development, better access to finance, and higher ownership dispersion. Lighter government ownership and regulation are in turn associated with less corruption, better functioning labor markets, and smaller unofficial or black market economies.
The flexibility of judicial decision-making under common law permits judges to be able or willing to enforce more flexible financial contracts, and such flexibility promotes financial development.
In civil law countries, the freedom to make contracts is counterbalanced by the exercise of public power for the protection of workers in the French tradition, and the communitarian concept of the enterprise in the German case. In common law countries, contractual freedom is less encumbered by social concerns so contractual flexibility is greater.
Flexibility also empowers common law courts to use broad standards rather than specific rules in rendering their decisions. This ability enables judges to “catch” self-dealing or tunneling, and thereby discourages it. This is famously called the smell-test of common law.
All these contrasting features make financial and economic affairs in common law countries more efficient than in civil law countries, at least under non-turbulent and peaceful times. The conclusion is that common law countries are more protective of private property than French legal origin ones; and this is vitally important for financial market development.
Innovation is an area that is particularly sensitive to private property rights protection, as it either involves the creation of new property rights or the invention of new uses for existing property rights, which are therefore new property rights as well. The common law framework and institutions provide a better balance of incentives to reward innovators and the efficient spread of their benefits for users through the market.
Data on the ratio of stock market capitalization to GDP is very telling. The ratios in France over the period 1800-1980 are much lower than those in Great Britain (see Figure 1). The same is true for a broader sample of civil law countries that include France, Belgium, Italy, Mexico, Japan, Germany, Switzerland, Denmark, Norway and Sweden and common law countries that include Australia, Canada, Great Britain, South Africa, and the United States (see Figure 2).
How governments in the two legal systems respond to new needs both across activities and over time is different. In the toolkit of civil law, policies such as nationalization and direct state control are more prominent; in the toolkit of common law, there is more litigation and market-supporting regulation.
By specializing in “policy-implementing” solutions, the civil law system tends to expand the scope of government control to new activities when a need arises. Because the state’s presence on the ground is less pervasive under the common law, it tends not to rely as extensively on administrative solutions and more on “market-supporting” or “dispute-resolving” ones.
When the market system gets into trouble or into a crisis, the civil law approach is to repress it or replace it with state mandates, while the common law approach is to shore it up. For example, the regulatory responses to the Great Depression and financial crises of the 20th century were different across countries with different legal traditions.
In the 1920s and 1930s, the Dutch, Italian, Japanese, and Swedish governments responded to financial crises by substituting various mechanisms of state-controlled capital allocation for their stock markets. China’s attempt to prop up stock prices this summer with aggressive state mandates is a typical civil law-conditioned response.
Great Britain, Canada, and the United States, on the other hand, responded to the Great Depression by introducing securities regulation and deposit insurance. These strategies were intended to rehabilitate and support markets, not replace them. They ultimately strengthened shareholder rights.
It is interesting to note that the stated goal of Qianhai New District in Shenzhen is to replicate the common law system within the district for the purpose of promoting financial market development. Time will tell whether this experiment will be successful. Hong Kong’s real competition today is not from Shanghai, but London and New York; perhaps someday Shenzhen will become a worthy competitor if the Qianhai experiment works.
Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, “The Economic Consequences of Legal Origins,” Journal of Economic Literature, 2008, 46:2, 285-332.