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This article was downloaded by: [Dicle University] On: 11 November 2014, At: 02:46 Publisher: Routledge Informa Ltd Registered in England and Wales Registered Number: 1072954 Registered office: Mortimer House, 37-41 Mortimer Street, London W1T 3JH, UK The Pacific Review Publication details, including instructions for authors and subscription information: http://www.tandfonline.com/loi/rpre20 Informal institutions and foreign investment in China Hongying Wang Published online: 26 Nov 2010. To cite this article: Hongying Wang (2000) Informal institutions and foreign investment in China, The Pacific Review, 13:4, 525-556, DOI: 10.1080/09512740010004269 To link to this article: http://dx.doi.org/10.1080/09512740010004269 PLEASE SCROLL DOWN FOR ARTICLE Taylor & Francis makes every effort to ensure the accuracy of all the information (the “Content”) contained in the publications on our platform. However, Taylor & Francis, our agents, and our licensors make no representations or warranties whatsoever as to the accuracy, completeness, or suitability for any purpose of the Content. Any opinions and views expressed in this publication are the opinions and views of the authors, and are not the views of or endorsed by Taylor & Francis. The accuracy of the Content should not be relied upon and should be independently verified with primary sources of information. Taylor and Francis shall not be liable for any losses, actions, claims, proceedings, demands, costs, expenses, damages, and other liabilities whatsoever or howsoever

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This article was downloaded by: [Dicle University]On: 11 November 2014, At: 02:46Publisher: RoutledgeInforma Ltd Registered in England and Wales Registered Number:1072954 Registered office: Mortimer House, 37-41 MortimerStreet, London W1T 3JH, UK

The Pacific ReviewPublication details, including instructionsfor authors and subscription information:http://www.tandfonline.com/loi/rpre20

Informal institutions andforeign investment inChinaHongying WangPublished online: 26 Nov 2010.

To cite this article: Hongying Wang (2000) Informal institutions andforeign investment in China, The Pacific Review, 13:4, 525-556, DOI:10.1080/09512740010004269

To link to this article: http://dx.doi.org/10.1080/09512740010004269

PLEASE SCROLL DOWN FOR ARTICLE

Taylor & Francis makes every effort to ensure the accuracy ofall the information (the “Content”) contained in the publicationson our platform. However, Taylor & Francis, our agents, and ourlicensors make no representations or warranties whatsoever asto the accuracy, completeness, or suitability for any purpose ofthe Content. Any opinions and views expressed in this publicationare the opinions and views of the authors, and are not the viewsof or endorsed by Taylor & Francis. The accuracy of the Contentshould not be relied upon and should be independently verifiedwith primary sources of information. Taylor and Francis shall not beliable for any losses, actions, claims, proceedings, demands, costs,expenses, damages, and other liabilities whatsoever or howsoever

Page 2: Informal institutions and foreign investment in China

caused arising directly or indirectly in connection with, in relation toor arising out of the use of the Content.

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Informal institutions and foreigninvestment in China

Hongying Wang

Abstract During the reform era, China has been very successful inattracting foreign direct investment (FDI) for its economic development .That this has taken place despite a rather weak legal system in Chinachallenges conventional institutional theories, which emphasize the centralityof effective state institutions to economic development and internationalcooperation. This article suggests that the solution to the puzzle lies in theinformal institutions underlying FDI development in China. On the basis of extensive interviews in the mid- and late 1990s, I �nd that networks ofpersonal connections (guanxi), which are pervasive in Chinese society, haveplayed a major role in facilitating FDI �ows to China. They have done soby complementing and compensating for the weak Chinese legal system.This article dispels a number of misconceptions about the nature of guanxi ,discusses its relationship with friendship, bribery, and social capital, andanalyzes the conditions underlying the transnationalization of guanxinetworks. It concludes with some important caveats to the major thesis anda discussion of possible future scenarios of institutional development inChina.

Keywords China; foreign direct investment; informal networks; socialcapital; economic institutions; transnational relations.

Introduction

The last twenty years, especially the last decade, have seen massiveamounts of foreign capital �owing to China. Much of it has been foreigndirect investment (FDI).1 In fact, since the early 1990s, China has becomeone of the top destinations of FDI in the world. Over the years, scholars

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Hongying Wang is Assistant Professor of Political Science at Syracuse University, USA. Sheis the author of Weak State, Strong Networks: The Institutional Dynamics of Foreign DirectInvestment in China, Oxford University Press, forthcoming.

Address: Department of Political Science, Maxwell School of Citizenship and Public Affairs, 100 Eggers Hall, Syracuse University, Syracuse, NY 13244, USA. E-mail:[email protected]

The Paci�c ReviewISSN 0951–2748 print/ISSN 1470–1332 online © 2000 Taylor & Francis Ltd

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and analysts have written extensively on the conditions under which FDIhas prospered in China (United Nations 1988; Grub and Lin 1991; Pearson1991; and Huang 1998). Most of them deal with the economic and policydimensions of this development. In contrast, this study focuses on theinstitutional dimension.

Institutions refer to rules of the game. They include formal institutionsthat take the form of laws and regulations and informal institutions thatare implicit norms and customs. This study of the institutional dynamicsof FDI in China shows the importance of informal transnational institu-tions. In doing so, it challenges conventional institutional theories of econ-omic development and international cooperation, particularly thecentrality they accord state institutions.

To begin with, it is helpful to brie�y review some of the central tenetsof institutional theories regarding economic development and inter-national relations. The study of economic development has produced awide range of theories of why some countries have achieved sustainedeconomic development and why others have not. In recent years, newinstitutional economics theory has become quite in�uential. The mostprominent contribution of new institutional economics to our under-standing of economic development comes from Douglas North and hiscolleagues (North and Thomas 1973; North 1990). According to Northand his colleagues, institutions set the rules of the game. In so doing, insti-tutions de�ne and limit the set of choices of individuals and reduce theuncertainties involved in human interaction. The economic performanceof a country depends critically on its institutional arrangements. Theabsence of ef�cient economic institutions that minimize transaction costs,i.e. the costs of information, measurement, and enforcement of propertyrights and contracts, has been at the root of the long-term economicstagnation of Third World countries. In contrast, Western industrializedcountries have developed a set of institutions that can ef�ciently controltransaction costs and reduce uncertainties. In particular, the rule of lawbacked by state coercion has been crucial to the development of modernWestern economies.2

In the last two decades, institutional theories have also become salient inthe study of international relations, creating a new school of thought knownas neo-liberal institutional (Krasner 1981; Keohane 1984; Rittberger 1993).The focus of this school is the role of international regimes, i.e. ‘principles,norms, rules, and decision-making procedures around which actor expecta-tions converge in a given issue-area,’ in facilitating international cooperation(Krasner 1981: 1). Like other institutions, international regimes reduce thecost of information, monitoring and communication. In so doing, theyenable cooperation and coordination among self-interested actors.Although there is nothing in the original de�nition that suggests inter-national regimes are necessarily intergovernmental, in reality this concepthas come to refer almost exclusively to state institutions.3

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Institutional theorists of economic development and internationalrelations both stress the crucial importance of the state and state institu-tions. From the point of view of those who study economic development,FDI, like other types of investment, requires the protection of an effectivelegal framework. From the point of view of those who study internationalrelations, FDI, like other types of cross-border transactions, demand inter-governmental cooperation governed by shared norms and principles.4

These theories offer valuable insights into the conditions of economicdevelopment and international cooperation in general and the �ow of FDIin particular. However, as this study attempts to suggest, they exaggeratethe importance of state institutions. To understand the institutionaldynamics of FDI – and indeed of economic development and internationalrelations – it is necessary to take account of the informal institutions aswell.

This article begins with a regression analysis of the determinants of FDI.The regression results indicate limited importance of formal state institu-tions to countries’ attractiveness to FDI and suggest the need to under-stand the informal institutions underlying FDI development. The bulk ofthe text focuses on the informal institutions underlying FDI developmentin China. It examines the centrality of personal networks in Chinesesociety, analyzes their functions in facilitating FDI, and discusses thetransnationalization of these networks. The �nal section introduces somecaveats to the major argument of this article and explores the futurescenarios of institutional development in China.

Determinants of FDI: a regression test

I propose the following regression exercise to examine the determinantsof FDI:

FDI = a + b 1i + b 2m + b 3l + b 4g + b 5s + b 6r + «

where i stands for the institutional factor; m, for market size; l, for livingstandard; g, for economic growth rate; s, for sunken investment; and r,for natural resources. In addition, a is a constant term, and « is a stochasticcomponent.

FDI represents the �ow at �ve-year intervals. To capture the institu-tional factor, I use Transparency International’s Corruption PerceptionIndex (CPI). The index is built on the results of a number of surveys of business executives as to how they perceive the seriousness ofcorruption in different countries.5 In using the CPI as an independent vari-able I assume that it re�ects the con�dence of business people in acountry’s legal system as it pertains to economic activities in general. Themore corrupt a country is perceived to be, the less con�dence investorshave in that country’s legal system. Market size is measured by gross

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domestic product (GDP). Living standard is measured by per capita grossnational product (GNP). Economic growth rate is measured by the annualrate of growth of GDP. I include ‘sunken investment’ in the equationbecause FDI, unlike portfolio investment, tends to be accumulative. Oncecompanies have made direct investment in a country, they are likely toadd to the investment because of the sunken nature of investment in theforms of factories, equipment, and trained local personnel. It is measuredby the FDI stock at the beginning of each period.6 Finally, I use countries’oil resources as a proxy for its natural resources.7

What this equation says is simply that a country’s FDI in�ow dependson the perceived effectiveness of its institutions, the size of its market,the living standards of its people, its economic growth rate, existing FDI,

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Table 1 Results of regression on FDI in�ow at �ve-year intervals (1980–95)

1980–85 1985–90 1990–95

Constant –4,469.070 –2,300.518 798.400(–1.675) (–0.390) (0.093)

Corruption perception 1,026.388 285.539 –657.888(1.716) (0.196) (0.316)

Resource dummy (oil) 2,880.948 –2,925.896 6.487(1.101) (–0.539) (0.001)

Existing FDI stock –0.166 1.218 0.268(–2.393)* (8.661)*** (4.657)***

GDP 2.775E–02 –2.373E–03 4.703E–03(14.685)*** (–0.417) (1.497)

GNP per capita –0.423 0.472 6.344E–02(–1.179) (0.837) (0.114)

GDP growth rate 149.620 411.556 2,624.850(0.433) (0.495) (2.233)*

R2 0.843 0.867 0.538N 66 69 71

(t-Statistics in parentheses) (*p , 0.05, ***p 0 , 0.001).

Notes and sources: FDI in�ows at �ve-year intervals are calculated by subtracting FDI stockat the beginning of the interval from FDI stock at the end of the interval. Figures are fromUNCTAD, World Investment Report (1997, 1998). Corruption perception �gures come fromTransparency International’s Corruption Perception Index of 1998. See http//:www.trans-parency.de (May 1999). The 1998 index is used throughout because countries’ scores havenot changed signi�cantly during the period. Regression run on aggregated measurementrather than actual scores of countries yield similar results. GDP for each period is the averageof nominal GDP of the �rst and the last year of the period, which are in turn calculatedfrom FDI �gures cited above and the percentage of FDI in nominal GDP in the samesources. GNP per capita for each period is the average of nominal GNP per capita �gures,which are found in World Bank, World Development Report (1982, 1987, 1992, 1997). GDPgrowth rate between 1970 and 1980 is used for FDI �ow of the 1980–85 period in the growthrate. GDP growth rate between 1980 and 1990 is used for FDI �ow of the periods of 1985–90and 1990–95. The �gures come from World Bank, World Development Report (1994, 1998/99).The resource dummy variable is measured according to whether a country exports oil. Datacome from UNCTAD, World Investment Report (1998).

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and whether it has special natural resources.8 The results of regressiontests for the three sample periods – 1980–85, 1985–90, and 1990–95 – arereported in Tables 1, 2, and 3.

Table 1 reports the regression results for all countries for which data areavailable. Market size is a statistically signi�cant determinant of FDI in the�rst period whereas sunken FDI is signi�cant in the second and third peri-ods. Economic growth rate is somewhat signi�cant in the third period.Perceived level of corruption is statistically insigni�cant in all three periods.

Given the obviously different economic and political conditions betweendeveloped countries and developing countries and the different logic ofinvesting in these two types of countries, it is helpful to run the same testfor them separately. As Tables 2 and 3 show, the results of separate testsfor the two types of countries are similar to the overall results.

For developed countries, market size is statistically signi�cant in the �rstperiod. Sunken investment is signi�cant in the second and third periods.The perceived level of corruption is not statistically signi�cant in any ofthe three periods. For developing countries, market size is statisticallysigni�cant for both the �rst and third periods. Sunken investment is signif-icant for the second and third periods. Economic growth rate is signi�-cant for the second period. The perceived level of corruption is notstatistically signi�cant for any of the three periods. In other words, forboth developed and developing countries, the important factors deter-mining FDI in�ow are market size, sunken investment, and economicgrowth rate. The perceived level of corruption is not important.9

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Table 2 Results of regression on FDI in�ow at �ve-year intervals in developedcountries (1980–95)

1980–85 1985–90 1990–95

Constant –13,745.31 26,008.019 40,662.413(–0.809) (0.766) (1.312)

Corruption perception 2,124.461 –1,874.844 1,758.327(1.194) (–0.409) (0.446)

Existing FDI stock –0.173 1.308 0.222(–1.414) (4.919)*** (3.346)**

GDP 2.860E–02 –5.805E–03 8.645E–03(8.429)*** (–0.506) (2.028)

GDP per capita –0.498 –7.422 –0.181(–0.608) (–0.056) (–0.208)

GDP growth rate 396.283 –208.137 –17,921.80(0.183) (–0.025) (–2.166)*

R2 0.850 0.853 0.737N 22 22 22

(t-Statistics in parentheses) (*p , 0.05, **p , 0.01,***p , 0.001).

Notes and sources: see Table 1.

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The apparent irrelevance of corruption perceptions suggests that the quality of the legal system as perceived by investors may not be asimportant to investment decisions as convention leads us to believe. Doesthis suggest institutions do not matter in the case of FDI? Given theaccumulated wisdom of new institutional economics, which clearlydemonstrates the impact of institutions on economic activities, a positiveresponse to this question is extremely dif�cult to contemplate. I proposea modi�ed hypothesis: i.e. the institutional environment of a host countrymatters to its attractiveness to foreign investors, but the institutional envi-ronment consists not only of its legal system, it also consists of informalinstitutions of various kinds. To discern the signi�cance of the institutionalfactor, in other words, one needs to look at both the formal and theinformal institutions.

Corruption perceptions re�ect foreign investors’ opinion of the effec-tiveness of the host country’s formal legal system, but they do not capturetheir view of the quality of informal institutions of the host country. Forone thing, it is much more dif�cult to obtain knowledge about the informalinstitutions of a country than it is to form an opinion about the formalinstitutions. In order to test how informal institutions affect FDI gener-ally, one needs to gather data about such institutions in a large numberof countries and then develop a scheme that measures and compares thesedata in a systematic way. Such a task is beyond the scope of this inquiry.Instead, this article offers a qualitative study of a single case. Through a

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Table 3 Results of regression on FDI in�ows at �ve-year intervals in developing countries (1980–95)

1980–85 1985–90 1990–95

Constant –2,447.201 –3,091.665 –3,738.305(–2.001)* (–2.369)* (–0.561)

Corruption perception 344.267 363.317 7.763E–02(0.952) (0.936) (0.000)

Resource dummy 1,689.572 1,269.039 –4,634.722(1.584) (1.183) (–0.836)

Existing FDI –0.84E–02 0.349 1.199(–0.757) (2.846)** (3.145)**

GDP 2.185E–02 1.058E–02 6.485E–02(3.593)** (1.441) (2.719)**

GNP per capita 0.284 0.507 –1.321(0.613) (1.583) (–1.642)

GDP growth rate 161.087 498.793 1,571.888(1.101) (2.494)* (1.757)

R2 0.490 0.748 0.706N 44 47 49

(t-Statistics in parentheses) (*p , 0.05, **p , 0.01, ***p , 0.001).

Notes and sources: see Table 1.

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detailed examination of the institutional conditions of FDI in China, ittakes a small step toward better understanding the institutional conditionsof FDI in general, especially the role of informal institutions.

Informal institutions and foreign investment in China

Despite the image of an authoritarian regime, the Chinese state is remark-ably weak. As many scholars have noted, during the reform period, thecapacity of the state to penetrate the society and to extract resources hasweakened dramatically (Hook 1996; Wang 1995). The weakness of theChinese state is also manifested in its inability to uphold an effectivesystem of rules. Since the beginning of the modern state system, stateshave been expected to set the rules of the game in each society. In fact,‘one can visualize the whole state as a legally arranged set of organs forthe framing, application, and enforcement of laws’ (Poggi 1978: 102). In this regard the Chinese state shows extraordinary weakness.10 Withregard to FDI development, as I have shown elsewhere, formal stateinstitutions are either ineffective or irrelevant. Neither domestic laws norinternational agreements provide reliable mechanisms for foreign investorsto minimize transactions costs and protect their business interests (Wangforthcoming). The weakness of state institutions renders investing in China apparently very risky. Foreign investors face a great number ofuncertainties in protecting their property rights, enforcing contracts, andsettling investment-related disputes.11 Nevertheless, foreign investment has �ourished in China (see Table 4). This is obviously contrary to theconventional wisdom of institutional theories. The key to understand this apparent puzzle lies in the strong informal networks in Chinese society.

Networks in Chinese society

Informal networks exist in every society. Even in the most advanced indus-trialized societies, which come closest to the Weberian ideal of a rationallegal order, informal networks play an important role in maintaining polit-ical order and facilitating economic activities, not to mention providingsocial cohesion. For instance, political patronage networks, old boys’networks in employment and professional development, and ethnicnetworks of economic and social support are prevalent in the UnitedStates. Informal networks dominate Japanese politics and economy. Butinformal networks in Chinese society stand out for three reasons: (1) thedegree to which informal networks contradict and undermine formal insti-tutions is extremely high; (2) the in�uence of informal networks is unusu-ally strong in every aspect of Chinese life; and (3) the level ofinstitutionalization of Chinese networks is very low. We examine thesecharacteristics in turn.

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First, Sinologists have long noted the remarkable gap between theof�cial and the unof�cial China. In the words of one prominent scholar,‘In China a wide divide has always existed between formal government,emanating from the imperial or national capital, and the private gover-nance that rules the daily lives of people . . .’ (Pye 1985: 292). This is insharp contrast with Western industrialized countries, where informal insti-tutions by and large run parallel with and reinforce formal institutions.For instance, North observes that while much of daily life in the modernWestern world is run by informal constraints, underlying these informalconstraints are formal rules (North 1990: 36). On the other hand, theformal state structure in Western industrialized countries that monitorsproperty rights and enforces contracts is built on the bases of informalconstraints, including ‘the respect for law and the honesty and integrityof judges’ (North 1990: 59–60).

Second, the in�uence of informal networks in Chinese society is extra-ordinary. Historically, informal institutions such as kinship, ancestorworship, and ritual played a central part in sustaining political order inChina (Chang 1983; Fried 1983; Savage 1985). A number of scholars havewritten about the prominence of informal politics in China in more recent times. For instance, Andrew Nathan’s factional model of politicsuses factions, i.e. vertically organized patron–client networks linked bypersonal connections, to explain con�ict and coalition among the CCPelites (Nathan 1973). Lucian Pye’s study of China’s political culture also

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Table 4 FDI in�ow in China (1979–98)

Contracted FDI (US$ billions) Utilized FDI (US$ billions)

1979–83 7.742 1.8021984 2.651 1.2581985 5.932 1.6611986 2.834 1.8741987 3.709 2.3141988 5.297 3.1941989 5.600 3.3921990 6.596 3.4871991 11.977 4.3661992 58.124 11.0071993 111.436 27.5151994 82.680 33.7671995 91.282 37.5211996 73.276 41.7251997 51.004 45.2571998 52.102 45.463

Total 567 267

Source: China Statistical Yearbook 1999, Beijing: China Statistics Press, 1999.

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situates factionalism at the center of his analysis, which he sees as deeplyrooted in Chinese culture and psychology (Pye 1981). While informal poli-tics exist elsewhere, it rules Chinese politics. In the words of a long-timeobserver of China, ‘Unlike most Western countries, where formal politicsis clearly dominant over informal politics and the relationship is one of“imposition and resistance”, the Chinese informal sector has been histor-ically dominant, with formal politics often providing no more than afaçade’ (Dittmer 1995: 16–17).

The role of informal networks in economic production and exchangehas been salient throughout Chinese history and in Chinese communitiesall over the world. In traditional China, family, kinship, and clans werenot only social organizations but important economic organizations aswell. Sanctioned and augmented by the state, these informal networksformed the basis of petty capitalism, which dominated Chinese economyfor centuries (Gates 1996).12 Even under communism, the quintessentialdistributive economy, informal personal connections played an active rolein the allocation of resources and organization of production. The gifteconomy challenged and undermined the planned economy of the state(Walder 1986; Oi 1989). During the reform era, which is marked by theintroduction and expansion of market mechanisms, informal networkscontinue to feature prominently in Chinese economy. Some scholarssuggest that China’s emerging economic order is not one of capitalism,but ‘network capitalism’ (Boisot and Child 1996). Others label the neweconomic order differently, but also readily admit the centrality of informalstructures (Pieke 1995; Wank 1999).

Third, compared with the informal networks in other societies, Chinesenetworks are even less institutionalized. To demonstrate the volatile natureof Chinese networks, it is helpful to compare those networks with theinformal networks in Japan. As noted by a number of scholars, both Chinaand Japan are network societies where informal rules are at least equallyimportant as formal ones. But they are not the same. Overall, Japanesenetworks are much more institutionalized. For instance, factionalism is ahallmark of Japanese politics. Factional cooperation or struggle, more thanthe formal rules of the government, determines policy and personnelchoices. Japanese factions are public and strictly hierarchical. Members ofthe factions carry out established informal conventions in a disciplinedway. In contrast, in Chinese politics the ties among members of a factionare secretive and do not have to be hierarchical. This makes Chinesefactionalism much more �uid than its Japanese counterpart. Moreover,powerful individuals could make major changes almost by whim (Pye 1985:286–99). In the economic realm, informal networks are equally importantin Japan as they are in Chinese society. Japanese business groups, such aszaibatsu and keiretsu, are based on long-term institutional ties betweencompanies and banks (Okumura 1991; Ueda 1991; Orru 1991; Lincoln et al. 1996). In contrast, Chinese business networks are based on intensely

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personal connections and depend very much on the bonds between partic-ular individuals.

Informal networks and FDI

Research based on extensive interviews with business people, lawyers,consultants, and government of�cials reveals the centrality of informalnetworks to the growth of FDI in China.13 While many of the interview-ees complain about the gross inadequacies of formal state institutions(domestic law and international agreements) in protecting foreign propertyand contractual rights, they �nd that the informal institution of guanxiprovides a viable alternative.

What is guanxi? Often translated as ‘relationships,’ ‘ties,’ ‘connections,’and ‘contacts,’ guanxi is a rich and complex concept. To put it most simply,guanxi refers to informal personal relationships based on trust and reci-procity.

First of all, guanxi is an informal relationship. People establish and main-tain guanxi through informal interactions. As a result, guanxi has no formalinstitutional legitimacy or expression, and guanxi networks do not corre-spond with formal organizational borders. Furthermore, the of�cial policyof the Chinese government has been to discourage the cultivation and use of guanxi. Consequently, people tend to engage in guanxi activitiesprivately, outside the of�cial domain.

Second, guanxi is a personal relationship. It is a framework in whichpeople relate to one another as individuals rather than role occupants.The establishment of guanxi often requires some common identity.14 Butthat in itself is not suf�cient. It takes personal interactions and sentiment(ganqing) to initiate and maintain guanxi (Jacobs 1979; King 1991; Yang1994). In politics this means personal loyalty exceeds policies and princi-ples. In the economic realm this means that transactions depend criticallyon personal rather than organizational trust and relationships.

Third, guanxi is a reciprocal relationship through which people exchangefavors. The favors exchanged range from scarce resources necessary indaily life to professional opportunities and political support. The exchangedoes not have to be immediate or direct; indeed ‘the return of a favor isstructurally uncertain’ (Yang 1994: 202). But in the long run, guanxi gener-ally involves repayment of favors in one way or another.

Fourth, trust is an important foundation of guanxi. Since guanxi is aninformal relationship of reciprocity, it cannot rely on formal institutionalguarantee of enforcement. Parties of a guanxi relationship can only rely ontheir con�dence in each other’s desire and capabilities to ful�ll their respec-tive obligations. Trust is often established and maintained through long-timeinteractions between the parties. Once trust breaks down, guanxi is over.

An analysis of the interview data shows that guanxi makes up for the weak legal system in China in two ways. First, it has been used to

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complement law, clarifying legal ambiguity and providing access to legalmechanisms of contract enforcement and dispute settlement. Second, ithas been used to secure business opportunities with high pro�t potentials,compensating for the high risks of investing in China.

As a complement to law, personal connections reduce the institutionalrisks of investing in China. During the initial stage, when companiesexplore or negotiate investment deals, information is crucial. Since Chineselaws and policies tend to be ambiguous and even contradictory, and since important regulations and information may not be available to thepublic, to rely on public documents and announcements alone is far from suf�cient. Well-connected individuals serve as an important sourceof dependable information. Beyond the negotiation stage, companiescontinue to rely on personal relationships to reduce uncertainties in busi-ness operation and to seek protection of their investment interests wherelaw falls short. In addition, guanxi constitutes a vital mechanism for con�ictprevention and resolution. As many business executives have learned,good relationships with local partners and of�cials reduce the chances ofcon�icts. When disagreements give rise to disputes, given the inef�ciencyand pitfalls of China’s judicial system, many companies rather avoidresorting to legal means and use guanxi to facilitate dispute settlement.Even when companies choose to use legal procedures to address businessdisputes, they need good contacts to increase the chances of a desirableoutcome.

In addition to complementing law, guanxi enables well-connectedinvestors to take advantage of the weakness of law. It does so by providingopportunities of striking extra-lucrative investment deals. For instance,according to a banker who is familiar with German operations, their pro�tmargins in China are much higher than in the United States. Indeed, forforeign investors who deploy personal connections well, the weakness oflaw can actually turn out to be bene�cial. Analytically, these two func-tions of guanxi are different. While the �rst function is to reduce the insti-tutional risks of investing in China, the second is to increase the pro�texpectation, which justi�es high-risk investment.

One type of good opportunities is in sectors not yet widely open toforeign investment. To get into these sectors, foreign companies need tocircumvent existing Chinese regulations in one way or another. To do so,personal connections are essential. Several companies interviewed arebene�ciaries of this kind of investment opportunities. Early entry putscompanies in a favorable position. More often than not, they have enor-mous advantages over local enterprises in terms of capital, technology,management know-how, and marketing. Given little competition fromtheir world-wide competitors, these companies are poised to make hand-some pro�ts. But early entry is not the only advantage for well-connectedcompanies. Another way to obtain pro�table opportunities in China is forforeign-invested enterprises (FIEs) to seek special status.

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Since the mid-1980s, the Chinese government has offered favorableconditions for FDI that is export-oriented and technologically advanced,such as tax reductions, loan priority, foreign currency priority, and exemp-tions from taxes on pro�ts remitted abroad. These measures are designedto attract FDI compatible with China’s economic development strategy.However, like other aspects of China’s legal system, the rules governingspecial status of FIEs are ill-de�ned and poorly implemented. In reality,whether or not an FIE is classi�ed as either ‘export-oriented’ or ‘tech-nologically advanced’ depends very much on negotiations with local of�-cials. If foreign investors have the right connections, they can gain specialstatus when they may not meet the of�cial standards (Roehrig 1994: 71–5).

In summary, the apparent contradiction between the weak legal systemin China and the massive foreign investment �ows into that country seemsmuch less puzzling in light of the ef�cacy of the informal networks. At amicro level, these networks reduce the risks and/or increase the expectedreturns of investment for companies. At a macro level, they play a pivotalrole in facilitating foreign investment in China. From the point of view ofthe Chinese government, the informal institution of guanxi has been anenabling factor for its policy of attracting foreign capital.15

Further analysis of guanxi

To re�ne our understanding of guanxi, it is important to put it in a comparative context. In this section, we �rst clarify the similarities anddifferences between guanxi on the one hand and friendship and briberyon the other. We then explore guanxi as a kind of social capital, comparingit with other types of social capital.

Guanxi, friendship and bribery

In his analysis of interpersonal relationships in China, Kwang-kuo Hwangidenti�es three kinds of ties – the expressive, the instrumental, and themixed ties. The expressive tie is based on affection. It occurs mostly amongfamily members, close friends, and other congenial groups. It is relativelystable and permanent. The instrumental tie, on the other hand, is estab-lished to attain speci�c goals. It often exists between people who interactwith each other on a short-term basis, such as a salesperson and a customeror a patient and a nurse. The mixed tie is somewhere in between. It is arelationship in which people seek to in�uence others by renqing (humansentiment) and mianzi (face). It takes place among people who know eachother and expect to interact with each other on a long-term basis (Hwang1987).

To a considerable extent, these three kinds of interpersonal relationshipsare embodied in friendship, bribery, and guanxi. While pure friendship is aform of expressive tie, bribery is a thoroughly instrumental relationship.

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Guanxi, which combines attributes of both, is best understood as a kind ofmixed tie.

Guanxi and friendship are similar in that both are informal personalrelationships based on trust. People who are linked through both kindsof relationships interact with one another outside formal institutions, relateto each other as individuals and on the basis of mutual trust. Moreover,in both kinds of relationships, people often engage in mutual assistance.Friendship can evolve into guanxi and vice versa. The boundary betweenthe two is blurred and highly permeable.16 In addition, like friendship,guanxi is often built on a common bond. Indeed, several intervieweesmake the connection between guanxi and friendship. They see guanxi asvery similar to friendship. For them, the way to build guanxi in China isnot all that different from the way to make friends anywhere else.

There is, however, an important distinction between friendship andguanxi. As Hwang points out, the exchange that takes place through theexpressive tie follows the need rule. In contrast, the exchange that isinvolved in the mixed tie follows some sort of equity or equality prin-ciple. In the case of friendship, which is a form of expressive tie, peopleprovide help for friends according to their needs. They do not expect tobe paid back for what they have done. In the case of guanxi, which is thequintessential mixed tie, people offer each other favors in a more or lessreciprocal fashion (Hwang 1987).

Both guanxi and bribery are informal particularistic relationshipsthrough which people exchange favors. In both cases, the central purposefor those who participate is to exchange goods, opportunities and otherkinds of bene�ts. Such exchanges take place outside formal institutions.They serve the particularistic needs of the participants and, in doing so,often undermine universalistic rules. Furthermore, in recent years mone-tary exchanges have come to be so salient in guanxi that sometimes theline between guanxi and bribery has become extremely hard to draw.

However, there are several distinctions between guanxi and bribery.First, the role of renqing and mianzi is different in these two kinds ofrelationships. While both of these elements are hardly present in bribery,they are central to guanxi. Unlike bribery, which is purely instrumentalexchange of favors, guanxi takes place among people who – directly orindirectly – are bound together by sentiments and social etiquette.

A second difference between guanxi and bribery concerns theirtemporal dimension. In the case of bribery, the parties often do not haveany historical ties. Their relationships are formed shortly before and specif-ically for the exchange of favors. The exchange of favors through briberyis a short-term transaction, involving a speci�c favor and immediatepayment. Guanxi, on the other hand, is a long-term relationship based onpersonal trust. It is often based on familiarity that has existed betweenpeople for a long time before the exchange of favors takes place. It is notdesigned to facilitate any speci�c exchange of favors.

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Third, although both guanxi and bribery often involve exchanges ofgifts, the nature of gift giving is different. Gifts in a guanxi context are amixture that contains an expression of goodwill and some long-term calcu-lations.17 The practical value is often less important than the symbolismembodied in the objects. But in bribery, the practical and monetary valueof gifts is the sole criterion for evaluating the relationship. It directly deter-mines if a favor is granted and how big the favor can be.

Finally, bribery is often an isolated dyadic relationship that is formeddirectly between the party that seeks the favor and the party that has thepower to grant it. In contrast, guanxi is a relationship embedded in acomplex social network. Among people in a guanxi network, the exchangeof favors does not have to take place directly between two parties. It ofteninvolves a chain of benefactors and bene�ciaries connected by interme-diaries (Yang 1994: 123–6).

Theoretical debate aside, in reality the boundaries between these typesof interpersonal relationships are by no means �rm or clear. In fact theyare often blurred and highly permeable. The word guanxi is used todescribe a variety of interpersonal relationships. Some of these relation-ships contain extensive expressive elements, bordering on friendship. Someare heavily instrumental, obscuring the border with bribery. Together theyform a continuum of mixed ties.

Guanxi as social capital

The widespread personal networks in Chinese society constitute a formof social capital. According to James Coleman, social capital ‘inheres inthe structure of relations between actions and among actors’ (Coleman1988: S98). It enables people to work together toward common goals. Inrecent years, the concept of social capital has gained increasing attentionin the analysis of political and economic phenomena. For example, RobertPutnam explores the decline of civil associations and its impact on thepolitical systems of Western societies (Putnam 1995). Francis Fukuyamaplaces trust at the center of economic development, arguing that the levelof impersonal trust in a society has been an important factor for econ-omic prosperity (Fukuyama 1995).

The kind of social capital embodied in guanxi networks is quite differentfrom the impersonal trust discussed by Putnam and Fukuyama. Indeed,the particularistic nature of guanxi seems exactly the opposite of whatthey view as social capital. In his study of comparative economic devel-opment, Fukuyama observes that Chinese societies are low-trust societies.There is little trust among people outside the family. That is why Chineseenterprises tend to be family businesses, which are small scale and inca-pable of expansion. Although he notes that networks provide one way toachieve scale of economies, he sees network relationships as based onkinship and thus quite limited in their potentials. The lack of impersonal

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trust, Fukuyama suggests, is going to be a major problem for China’seconomic modernization (Fukuyama 1995).

However, if social capital refers to social structure that enables coop-eration, guanxi certainly is a kind of social capital. The particularisticnature of guanxi does not necessarily make it anti-social or anti-cooper-ation outside a small group. To understand guanxi as social capital, it ishelpful to dispel some common misconceptions.

First, guanxi networks have never been based solely on family andkinship. In his pioneering study of the social structure of China, MortonFried explores various social networks. He �nds that the village resident‘lives much of his life beyond the orbit of relationships provided either byhis family or the kinship system in which he is involved’ (Fried 1953: 218).Extra-kin relationships are diverse and prevalent. They ‘ramify through the entire social structure and furnish the links between kin-based activityand movements in the larger civil areas of society’ (Fried 1953: 230). Otherstudies of guanxi con�rm this conclusion (Yan 1996; Jacobs 1979).Moreover, the kinship element has been decreasing over time. MayfairYang’s study of guanxi in contemporary China shows ‘kinship is one basefrom which guanxi overtures may be made, but in large cities it is no longerthe main basis for two people entering into guanxi exchange’ (Yang 1994:113). Other common bonds, such as school and work ties, are becomingmore important. This means that guanxi networks are personal but not atall limited to family and kin. People build informal particularistic relation-ships of reciprocity with a wide range of others (Ruan et al. 1997).

Second, guanxi can be highly transitive. As mentioned above, peoplewho do not directly know each other could engage in exchanges of favorsthrough guanxi as long as there are trusted intermediaries. Indeed, muchof the reciprocity in a guanxi network is carried out indirectly throughmiddlemen. Sometimes, there are intermediaries between intermediariesand they are all connected by mutual indebtedness. Through a long chainof reciprocity, individuals are not only able to exchange favors with theirimmediate links, but through those links, with a large number of others.18

The viability of non-family and non-kin relationship as a basis for guanxiand the highly transitive nature of guanxi make guanxi networks open toa wide range of people. Contrary to the stereotypical image of exclusivity,guanxi networks are entirely accessible to non-Chinese.19 In other words,informal networks based on guanxi constitute social capital that has thepotential of transnationalization. The next section discusses the structureand agents of the transnationalization of the informal personal networksthat have played such a crucial part in facilitating FDI in China.

Transnationalization of informal networks

Transnational relations can be de�ned as regular interactions acrossnational boundaries when at least one actor is a non-state agent or does

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not operate on behalf of a national government or an intergovernmentalorganization (Risse-Kappen 1995: 3). A number of recent case studies oftransnational relations demonstrate that ‘domestic structures mediate,�lter, and refract the efforts by transnational actors and alliances to in�u-ence policies in the various issue-areas.’ Speci�cally, they �nd that ‘themore fragmented the state structure, the less capable should nationalgovernments be to prevent transnational activities’ (Risse-Kappen 1995:25, 26). The argument of this section is parallel to this point of view, i.e.the fragmented nature of China’s political and economic system has beenconducive to the transnationalization of informal networks facilitatingforeign investment.

While internal divide of various types makes China’s domestic politicalstructure susceptible to transnational relations, bureaucratic and regionalcompetition have been the most signi�cant source of opportunities fortransnational networks in the realm of FDI.

Bureaucratic competition

Bureaucratic politics is common to various types of political systems(Wilson 1989). China is no exception. Bureaucratic con�icts have longbeen part of Chinese politics (Buchman 1991). Economic reforms haveonly made such con�icts even more visible (Lieberthal and Oksenberg1988; Lieberthal and Lampton 1992). Speci�cally, administrative reformsin the last two decades have created new incentives and opportunities forgovernment agencies to compete with one another for economic resources,including FDI.

Administrative reforms in China involve a number of dimensions,including decentralizing power from the very top of the central govern-ment to lower levels of ministries and agencies, replacing political disci-pline with professional ethics, and reducing the size of the bureaucracy(Burns 1993a, 1993b; Bennett 1993; Ma 1996; Liou 1998). As a result ofthese reforms, government ministries and agencies and bureaucracy-turnedsemi-governmental corporations have been given increased decision-making authority and �nancial responsibilities, which in turn motivatethem to maximize economic bene�ts.

Of particular relevance to the development of FDI is the decentraliza-tion of the governance of China’s foreign economic relations. Before thereform, foreign trade – the main form of foreign economic relations – wasstrictly controlled by the Ministry of Foreign Trade (which later becamethe Ministry of Foreign Economic Relations and Trade and is now theMinistry of Foreign Trade and Economic Cooperation). Under the reformprogram, this has changed. The authority to engage in foreign trade andto introduce FDI has been delegated to many ministries and ministry-turned state corporations. They have gained the right to seek and approvea wide range of FIEs and to bene�t from the �nancial and technologicalgains brought by FDI.

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In addition to the administrative reforms, the expansion of the grayeconomy has also contributed signi�cantly to the commercial competitionamong government bureaucracies. Since the late 1970s the nature ofChina’s economy has changed signi�cantly. The weight of the state sectorhas decreased steadily (Naughton 1995; Lardy 1998; Steinfeld 1998).However, China is far from being a market economy. Government agen-cies and of�cials continue to intervene in the economy in a heavy-handedway. This transitional period is characterized by a wide gray economicarea, in which the public and the private, power and wealth, legitimateand illegitimate interests intermingle with one another. In such an envi-ronment, government bureaucracies both regulate and participate in theeconomy. State bureaucracies have become entrepreneurial (Duckett 1996;Gore 1999).20

These changes have brought about tremendous incentives to competefor foreign investment, which provides a number of quick and easy econ-omic bene�ts, such as capital, technology, and market access overseas. Asa result, in recent years, of�cials from various government agencies andagency-turned conglomerates have been actively trying to entice FDI tosupport their own development priorities. Even the People’s LiberationArmy has actively engaged in joint ventures with foreign investing compa-nies (Mulvenon 1998).21

Regional competition

Throughout its history, the PRC has seen the pendulum swing betweencentralization and decentralization. Since the late 1970s, under the econ-omic reform program, the central government of China has steadilyloosened economic and political control. This involves a shift of resourcesfrom the national to the sub-national authorities and an expansion ofdecision-making power on the part of regional and local governments.22

While decentralization has created unprecedented economic prosperity in many parts of the country, it has also weakened the center’s capacity toenforce its policies (Wang and Hu 1993; Jia and Lin 1994; Goodman andSegal 1995; Wu and Zheng 1995). Time and again, Beijing has openlywarned regional governments against centrifugal tendencies such asresisting the center’s macroeconomic control measures and evading centraltaxation.

In addition, economic reforms have also changed the regional devel-opment patterns in China. As coastal China takes off with high growthrate, inland regions have, by and large, been left behind. Research shows that regional disparities have increased during the reform (Wangand Hu 1999). Moreover, the shrinking of central government revenueshas made it increasingly dif�cult for Beijing to effectively redistributeresources through �scal means, a traditional remedy for regional in-equality.

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These two tendencies – decentralization of power from the nationalgovernment to local governments and a growing sense of inequality amongregions – have led to increasingly open and �erce competition among theregions. Since FDI brings quick economic bene�ts (foreign capital, tech-nology, employment opportunities and revenues) and political payoffs (thenumber of foreign investment projects is often a major criterion in theevaluation of of�cials’ performance), local government of�cials are highlymotivated to attract foreign companies. In the process of competing witheach other to host foreign investing companies, provincial and localgovernments have taken a wide range of measures, including improvinglocal infrastructure (power, roads, ports, telecommunications, etc.), simpli-fying bureaucratic procedures, and, above all, setting up numerous so-called development zones, where foreign companies are given privilegesin land use and taxation. These development zones have, at times, grownout of control. For instance, by the early 1990s, the State Council hadapproved only thirty national development zones. But provincial and localgovernments had set up more than 8,000, many of which were illegal(Zweig 1998). The frantic competition for FDI can be very confusing toforeign investors. But for those who know the Chinese system well, thissituation creates opportunities to develop good relationships with localgovernments that facilitate their investment.

The ethnic Chinese connection

In addition to the fragmented nature of China’s domestic structure, whichmakes room for transnational relations, the tens of millions of ethnicChinese living outside China have been active agents of the transnation-alization of guanxi networks.

Ethnic Chinese outside of China have a number of advantages overother foreign investors in resorting to personal networks for investmentpurposes. First, they have the cultural advantage, which has two aspects.One aspect of the cultural advantage is distinctively Chinese. It refers totheir understanding of the Chinese language and the art of personal rela-tionships in a culturally Chinese context. Wherever they live – certainlyin Hong Kong, Taiwan, and Southeast Asia – most ethnic Chinese knowat least one Chinese dialect. They are familiar with the norms and prac-tices of mianzi, renqing and other fundamentals of network building. Theeconomic success of overseas Chinese in recent years has in large partresulted from the informal networks they have created. These networksbased on family, kinship, and other types of common bonds provide anef�cient way for Chinese business people to obtain information, raisecapital, reduce labor cost, and enforce contracts (Wang 1990; Redding1991, 1993; Hamilton 1996; East Asia Analytical Unit 1995).

The other aspect of the cultural advantage, which is often neglected, isnot uniquely Chinese.23 It refers to the practical knowledge of operating

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in developing countries, where the institutional environment is similar tothe one in China. Companies from Hong Kong, Taiwan, and SoutheastAsia have long operated in political and economic systems that lack therule of law.24 They have learned to protect their interests through networksof mutual support and political cooptation (Skinner 1958; Mackie 1992).The tactics they have developed in dealing with uncertainties elsewherehave come in handy as they encounter similar problems in China.

Second, ethnic Chinese have concrete human connections in China.Since ethnic Chinese have ancestral homes and roots in China, they caninvoke these ties as the basis of familiarity and close relationships.Moreover, many Chinese living elsewhere in the world still have relativesand friends in China, with whom they can easily reconnect and developstrong personal ties (Liu 1998). These qualities are particularly true ofmore recent immigrants.

The third advantage has to do with the decision-making procedure ofethnic Chinese companies. Most of the ethnic Chinese companies arefamily-owned. Although in recent years some of them have been listedas public companies, they remain under the effective control of thefounding families. As a result, the decision-making procedures in thesecompanies are both secretive and fast. When the top management of acompany spots a business opportunity, they do not have to consult others– banks or shareholders – and can decide to move in very soon. They arein a unique position to take on investment projects that at �rst seemextremely risky.25

In addition to making investment in China themselves, ethnic Chineseoutside China have also played a major role in facilitating FDI from otherforeign companies. Foreign companies seeking to invest in China realizethe advantages of ethnic Chinese in adapting to China’s institutional envi-ronment. Many of them have used Chinese employees or middlemen tofacilitate their negotiations and operations, including Chinese studentsboth returning to China and remaining abroad (Rubin 1995). More andmore foreign companies are also allying themselves with ethnic Chinesecompanies in making investment in China. Without the agency of ethnicChinese, it would have been much more dif�cult for foreign companiesto use personal networks to complement and compensate for the weakformal legal institutions in China.26

Caveats and conclusion

So far this article has demonstrated the important role of informal personalnetworks in facilitating FDI. This section seeks to put this analysis inperspective. It does so, �rst, by stressing that, useful as they are, guanxinetworks are not perfect in protecting the investment interests of foreigncompanies. Second, it addresses the question of whether guanxi, whichhas been of central importance in the last two decades, will continue todominate the institutional environment of FDI in China in the future.

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The limits of guanxi

The limits of guanxi can be seen at both a micro and a macro level. Fromthe micro perspective of foreign companies, personal relationships providea solution to the institutional problems of investing in China. But depen-dence on personal networks also has some real and potential drawbacks.First, it can be dif�cult and costly to build and maintain good relation-ships with all the relevant actors. Second, the personal nature of guanxinetworks means that it depends on the presence of key individuals. Ifthese individuals change positions or lose power, FDI projects based ontheir protection may suffer setbacks or be doomed altogether. Third, thelack of transparency of guanxi networks makes it dif�cult to distinguishtruly useful connections from phony claims. Finally, as mentioned before,given the increasing stakes involved in gift giving and banquets, the linebetween guanxi and bribery has become very ambiguous. Perceivedmisconduct may be costly to companies’ reputation, a long-term loss thatis often not justi�ed by short-term gains.

Aside from the micro-level consequences, there are reasons to believethat the prominence of personal networks in facilitating FDI in China hashad a major impact on the overall investment patterns in China.Theoretically speaking, a guanxi-dominated institutional environment islikely to privilege investors who are well-connected and investmentprojects suitable for the kind of protection provided by personal connec-tions. Three speci�c hypotheses follow. First, as noted above, ethnicChinese have considerable advantages over other types of investors inbuilding personal connections in China. Therefore, we should expect ethnicChinese companies to be leading investors in China. Second, given thecultural proximity between coastal Chinese provinces, especiallyGuangdong and Fujian, with ethnic Chinese communities in Hong Kong,Taiwan and Southeast Asia, we should expect these provinces to be mostsuccessful in attracting FDI.27 Third, the personal nature of guanxi makesit less suitable for large investment projects that involve a large numberof actors and long-term commitment than for small investment projectsthat involve a limited number of actors and promise quick returns. Thus,we should expect FDI in China to be concentrated in small projects.Related to that, informal personal networks are not suitable for the protec-tion of intellectual property rights because potential violators are toonumerous and dispersed. Therefore, one should expect low and guardedtechnological input in FDI projects in China.

These hypotheses are by and large born out by empirical evidence. First,as shown in Figure 1, from 1979 to 1998, investment from Hong Kong(including Macao), Taiwan, and Singapore accounted for 70 per cent ofFDI in China. If investment from these three regions is omitted, China’srecord of FDI would look much less impressive.28 In fact, according toone analyst, despite China’s overall success in generating FDI, relative toan ‘average’ host country, it has received too little foreign investment from

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the four major sources of FDI in the world – the US, Germany, France,and the UK (Wei 1995). While the Chinese government continues towelcome ethnic Chinese capital, of�cials have repeatedly called for moreinvestment from large multinational corporations in Japan, Europe, andNorth America.

Second, with regard to the geographical distribution of FDI, the bulkof it has been made in the coastal regions (see Figure 2). Between 1979and 1998, Guangdong and Fujian absorbed 38 per cent of all the FDImade in China, with Shanghai and Jiangsu taking in another 21 per cent.At the beginning, limiting FDI in Guangdong, Fujian, and other areasalong the coast was a useful way for China to experiment with reformsand to introduce the open policy in a gradual fashion. However, over theyears the persistent concentration of FDI in coastal areas has worsenedthe regional imbalance of economic development in China. The Chinesegovernment has been concerned about this problem for some time. In the1990s the Chinese government has explicitly encouraged foreign capitalto invest in inland China. So far the trend toward concentrated invest-ment in coastal China has not been reversed.

Third, in terms of the size of investment projects, FDI in China consistsof a small number of large investment projects and a large number ofsmall projects. The average size of contracted FDI projects was little morethan $1 million in the early 1990s. Since then it has gradually increased,approaching $3 million in the late 1990s. Moreover, the capital actually

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12%

Japan8%

US8%

Taiwan8%

Singapore3%

Hong Kong59%

Figure 1 Major sources of actually utilized FDI in China (1979–98)Source: Almanac of China’s Foreign Economic Relations and Trade, Beijing: ChinaEconomic Publishing House, various years.

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utilized has been much less than the contracted amount. The small FDIenterprises are often involved in simple labor-intensive rather thancomplex capital-intensive and technology-intensive production. Althoughsome FDI projects have transferred new technologies to Chinese enter-prises, they have been a minority (Wang et al. 1992; Lan 1996; Wang 1997).

The future of guanxi

Will China’s institutional environment change? Will informal personalnetworks continue to be a central part of the institutional mechanismsfacilitating FDI in�ow in the future? Or will economic development bringabout a stronger system of rule of law in China?

Economists tend to believe in institutional convergence. Drawing ontheir study of economic actors such as �rms, they argue that different soci-eties may begin with distinctive economic institutions. But in time thepressure of competition will force them to opt for the most ef�cient insti-tutional arrangements, or else they will be left out. In other words, nomatter what idiosyncratic institutional arrangements countries begin with,as they interact and compete with one another, they will graduallyconverge institutionally (Alchian 1950; Friedman 1953). If this evolu-tionary hypothesis is correct, as China becomes further integrated intothe international economic system, through trade, investment, and otherlinkages, one should expect its economic institutions to become a copy of

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Guangdong28%

Other41%

Shanghai9%

Jiangsu12%

Fujian10%

Figure 2 Regional distribution of actually utilized FDI in China (1979–98)Sources: Almanac of China’s Foreign Economic Relations and Trade, Beijing: ChinaEconomic Publishing House, various years.

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the most ef�cient model, i.e. the model of Western industrializedeconomies. In other words, a guanxi-dominated institutional environmentwill be replaced by one based on the rule of law.

The evolutionary argument for institutional convergence makes logicalsense. Furthermore, there is some evidence of a gradual shift from personalparticularism to impersonal universalism in the most developed areas ofChina (Guthrie 1998). If this trend continues, it is possible that China’seconomy becomes more market-oriented and more integrated in inter-national economy, its economic institutions will move toward rule of lawand the role of personal relationships will decline.

However, the convergence theory has several problems. First of all, the analogy between �rms and states may be useful as a heuristic device,but it is fundamentally �awed. States are not �rms. Even if one acceptsthat an economic system based on universalistic rules is more ef�cientthan one based on personal relationships, it is not likely that the pressureof competition will force states to adopt that system. While �rms areweeded out by competition all the time, even the most inef�cient statesrarely meet such a fate. Contrary to the evolutionary perspective, it isentirely possible for states that are grossly inef�cient to survive for a longtime.

Second, it is not clear that a rational legal system is indeed the mostef�cient economic system. A system based on the rule of law has obviousadvantages over its alternatives. But it is far from problem-free. For onething, a system based on procedural rationality does not ensure substan-tive rationality (Simon 1978). Actors in such a system, like actors in othersystems, face constraints of information and ideology. By following arational procedure, they do not necessarily achieve rational outcomes(North 1990: 95–6). Furthermore, the emphasis on formal legal proceduresoften imposes its own costs on economic transactions. The US may comeclosest to the ideal of a rational legal system. But even there, due to thecost and inef�ciency of litigation, the reliance on law is limited. Businessesoften rely on relational contracts and solve contractual disputes throughinformal mechanisms (Macaulay 1963; Macneil 1985). On the other hand,a number of economies in East and Southeast Asia, such as Taiwan, Korea,and Japan, provide notable examples of strong economic developmentwithout Western-style systems of rule of law. Like China, human connec-tions are very important for the security of property rights and the enforce-ment of contracts in those societies (Hamilton 1991). And like China, theyhave experienced sustained economic growth. The �nancial and economicproblems of the 1990s notwithstanding, their remarkable records of growthdemonstrate the viability of alternative models of economic development.

A third challenge to the convergence thesis is that the direction andpace of institutional change face serious constraints. Institutional econ-omists regard economic institutions as mechanisms for minimizing costsand maximizing bene�ts. For them the evolution of economic institutions

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has been a story of relentless pursuit of ef�ciency. This functionalistperspective has been effectively challenged by economic sociologists, whopoint out that changes in economic institutions are constrained by theproblems of path dependence and embeddedness.

Path dependence refers to the tendency for past decisions to narrowfuture choices. In terms of institutional evolution, it implies that peoplemake initial choices of institutions under great uncertainties. But once the choices are made, because of the increasing returns to the choseninstitutions, they are likely to prevail even if they turn out to be lessef�cient than alternative institutions (March and Olsen 1984; David 1985).According to this logic, guanxi is likely to dominate China’s futureeconomic development, including FDI development. The more foreigninvestors and their Chinese partners have come to master the art of guanxi and the more they rely on personal connections to circumvent ortake advantage of the weakness of China’s legal framework, the fewerincentives they have to change the existing institutional environment.Moreover, while personal relationships alleviate the lack of legal protec-tion for foreign investment in China, once such extra-legal mechanismsbecome routinized, they further undermine the rule of law. In other words,a partial solution of the problem can make the problem worse in the longrun.

In addition to being path dependent, institutional change is constrainedby the problem of ‘embeddedness.’ Economic organizations and normsare not designed in a vacuum and do not necessarily meet the universalstandard of ef�ciency. Instead, they are embedded in the local social and cultural context. Different social and cultural structures and ethosproduce different economic institutions and behaviors (Granovetter 1985;DiMaggio 1994; Hamilton 1994).29 In other words, certain norms and rulesof a society extend across all areas and provide the basis of various insti-tutions, including economic institutions (DiMaggio and Powell 1991).30 Asdiscussed earlier, guanxi has long been central to Chinese politics,economy, and society. The institutional framework governing FDI has torespond to the larger overall institutional environment in China. As longas personal networks dominate China’s political, economic, and social rela-tions, their role in FDI is likely to continue.

Finally, institutional changes are constrained by the political structureand balance of power among different interest groups. Institutions are not chosen by people to achieve economic ef�ciency. They are imposedby the politically powerful, who maintain institutional arrangements that bene�t their private interests more than the interests of others, andsometimes even at the expense of public interests (Bates 1995; Soltan1998). The partial reforms in China have created a large number ofbene�ciaries of the existing system, including of�cials at all levels of the government. Their political power forms a formidable obstacle to thestrengthening of an impartial, effective legal system.31

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In light of these factors, it seems reasonable to expect slow and incre-mental institutional changes in China in the direction of the rule of law.But despite these changes, the institutional conditions of FDI in China –and, for that matter, its economic institutions in general – will continueto diverge from the rational legal ideal. Despite their obvious limitations,networks of informal personalistic connections will remain a central mech-anism for the exchange of information, protection of property and enforce-ment of contracts in the foreseeable future.

Acknowledgments

I would like to acknowledge the �nancial support of the SSRC-MacArthurFoundation program in international peace and cooperation, the Institutefor the Study of World Politics, Women in International Security, SanDiego State University, and the East Asian Institute of the NationalUniversity of Singapore. I thank Roger Cliff, Michael Doyle, RobertGilpin, Harry Harding, Peter Katzenstein, Samuel Kim, Mike Oksenberg,Jeremy Shiffman, and Lynn White for their comments at various stagesof my research and writing.

Notes

1 Foreign direct investment refers to foreign equity investment that constitutesa signi�cant percentage of ownership (above 10%). It involves a relativelylong-term commitment and participation in management.

2 Not all the new institutional economists share this emphasis on state institu-tions. For instance, in contrast to North, Williamson neglects the statecompletely (Williamson 1985).

3 According to Robert Keohane, ‘International regimes are institutions withexplicit rules, agreed upon by governments, that pertain to particular sets ofissues in international relations’ (Keohane 1993: 28–9).

4 Charles Lipson’s study of international capital �ows in the last two centuriesaccords primary importance to states, especially hegemonic states, in settingand maintaining the rules for the treatment of foreign investment (Lipson1985).

5 The index of 1998 comes from the following sources: Economist IntelligenceUnit (Country Risk Service and Country Forecasts), Gallup International (50thAnniversary Survey), Institute for Management Development (WorldCompetitiveness Yearbook), Political & Economic Risk Consultancy (AsianIntelligence Issue), Political Risk Services (International Country Risk Guide),World Development Report (private sector survey by the World Bank), andWorld Economic Forum & Harvard Institute for International Development(Global Competitiveness Survey). See http://www.transparency.de (May 1999).

6 FDI stock as of a certain period refers to accumulated FDI by that period.FDI �ow in a certain period refers to the amount of FDI made in that period.

7 While natural resources (including renewable and un-renewable resources)continue to shape companies’ investment locations, resource-based FDI hasbecome less and less important. From 1970 to 1990, for the largest developedcountries, the portion of primary sector FDI in the total inward FDI stock fell

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from 16 to 9 per cent. For the largest developing countries, the averagepercentage was around 22 per cent. And most of the natural resource-basedinvestment is in the business of petroleum (UNCTAD 1998: 85).

8 Conspicuously missing from the model are labor cost and political stability.These variables are left out deliberately. Labor cost is important for sometypes of FDI. But it is dif�cult and perhaps counter-productive to incorporateunit labor cost in the model because it is often compounded by the labor skillfactor. Companies are willing to invest in a country even if the labor cost thereis high provided it has highly skilled labor. So the model here does not includeunit labor cost as an independent variable. Political stability ought to be animportant factor in shaping investment decisions. However, regression testsfrom a variety of sources indicate that it is not statistically signi�cant as anindependent variable (UNCTAD 1998: 139; Svensson 1998).

9 This conclusion is similar to the �ndings of the econometric tests reported inthe 1998 World Investment Report, which �nd no relationship between govern-ment ef�ciency (which combines ratings for judiciary system, red tape, andcorruption) and the residuals from an equation that includes GDP, GDP percapita, and GDP growth (UNCTAD 1998: 136–8).

10 It is important to note at the outset that the weakness of a state in upholdingthe law does not mean that the state is paralyzed or inactive. In fact, theChinese state continues to play a dominant, albeit diminished, role in thecountry’s politics and economy. Ironically, the arbitrary power of the stateundermines its capacity to implement and enforce the rules it has set for itselfand society.

11 Institutional risks are different from political risks. Political risks refer to uncer-tainties related to a country’s political situation. They often include civil strife,war, political instability, nationalization, and other types of major policy shifts(Brewer 1985). Institutional problems, on the other hand, refer to the uncer-tainties created by the institutional environment of a country. They tend to beless dramatic, but more prevalent.

12 Gates de�nes petty capitalists as ‘commodity producers – producers for marketmore than for use – through �rms organized in the idiom of kinship’ (Gates1996: 7).

13 These include 67 interviews with investors from 46 companies (26 from theUS, 9 from Hong Kong, 7 from Europe, 2 from Southeast Asia, 1 from Taiwan,1 from Japan, and 1 from Canada); 67 interviews with 61 observers (mainlylawyers, consultants, and government of�cials) (22 Americans, 14 Chinese, 9Europeans, 6 Hong Kong Chinese, 6 Japanese, and 4 Southeast Asians). Theinterviews were conducted in 1994, 1995, and 1998.

14 For instance common last name (tongxing), common ancestor (tongzong),common hometown (tongxiang), common school (tongxue), common occupa-tion (tonghang), and common workplace (tongshi).

15 This is not always true of informal institutions in China. When comparinginformal networks in China with those in Japan, Lucian Pye points out,‘Whether the pattern of such networks adds up to power for the institutionor becomes an inhibiting force is almost a matter of chance’ (Pye 1985: 291).

16 Norman Kutcher (Kutcher forthcoming) notes that the concept of friendshipin Chinese society seems to involve more mutual obligations than in Westerncultures. This makes the distinction between friendship and guanxi all the moremurky.

17 Yunxiang Yan (Yan 1996) classi�es gifts in a Chinese village into three cate-gories – expressive gift giving on ceremonial occasions, expressive gift givingin non-ritualized situations, and instrumental gift giving.

18 Anthropologists call this ‘generalized reciprocity.’

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19 Even ethnic Chinese banking networks in Asia are open networks, incorpo-rating non-Chinese participants (Hamilton-Hart 1998).

20 Marc Blecher (Blecher 1989) makes a distinction between two models: ‘devel-opmental state’ (in which government creates conditions for development) andentrepreneurial state (in which the government undertakes pro�t-making activ-ities).

21 In 1998 President Jiang Zemin of China ordered the military to stop engagingin business operations. It is too early to say if the ban has been effective.

22 It is important to note that decentralization involves not only increasedauthority but also increased responsibility for local governments. Fiscal decen-tralization has been much less favorable to local governments than commonlyassumed (Wong 1991).

23 Rupert Hodder (Hodder 1996) goes so far as to argue that there is nothinguniquely Chinese about the business practices of overseas Chinese.

24 Like mainland China, Taiwan and Southeast Asian countries are run bypersonal connections more than by law. Hong Kong was similar until the mid-1970s. Since then, Hong Kong has signi�cantly improved its legal system,moving toward a society of law. But there are signs of the trend being reversedwith its integration into the Chinese economic system.

25 In addition to the business organization, there are other reasons for theapparent risk-prone behaviors of ethnic Chinese companies, including the envi-ronment (Redding 1993: 202) and Chinese merchant culture (Wang 1990:19–20).

26 The existence of a large diaspora has not only helped China in attracting FDI,the same has been true of Vietnam (Zielenziger with Rees 1995). In contrast,the lack of such a diaspora may have been a major reason of Russia’s poorrecord in attracting FDI. Like China, Russia has tremendous natural andhuman resources as well as market potentials. The Russian government hasbeen actively appealing to international businesses to invest in Russia. But sofar, the amount of FDI in Russia has fallen far behind that in China.

27 Linguistically and culturally, Guangdong is very close to Hong Kong, as Fujianis to Taiwan. Historically, Guangdong and Fujian have also been feeders ofemigrants to Southeast Asia and other parts of the world.

28 It should be noted that not all FDI listed as coming from Hong Kong andMacao originates in those two areas. Many corporations from the West andelsewhere in Asia make investments in China through their regionalsubsidiaries registered in Hong Kong and Macao. Moreover, since the begin-ning of the reforms, an increasing number of mainland Chinese companieshave set up business enterprises in Hong Kong and Macao. Many of them usethese enterprises to bring capital back to China in order to take advantage ofprivileges reserved for foreign investors. Some estimate that this kind of round-tripping foreign investment accounts for roughly a quarter of the FDI fromHong Kong and Macao (Zhang and Tracy 1994: 3; Huang 1998: 56–70). Whileit is extremely dif�cult to calculate what percentage of the FDI �owing fromHong Kong and Macao to China originates from where, it is safe to say thatmost of it is ethnically Chinese capital.

29 This idea goes back to Max Weber. Weber sees all institutions, including econ-omic institutions, as anchored in civilizations (Weber 1978/1922). Karl Polanyiand his colleagues make the same point (Polanyi et al. 1971/1957).

30 This is often referred to as ‘institutional isomorphism.’ 31 Some scholars (e.g. Hellman 1998) argue that partial reforms may block further

reforms in former communist countries. Others (e.g. Gore 1998) emphasizethe effectiveness of the partially reformed system in mobilizing resources forindustrialization. These two views are not mutually exclusive.

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