Institutions don't matter as much as the ability to keep a promise to foreigners do.
Almost three decades ago an Indian diplomat just back from a three-year posting in Peking -- as it was known then -- told me that the Chinese were master illusionists and that they could make the world believe just about anything about their country.
Fresh proof of this insight comes in a recent paper by Joseph P H Fan, Randall Morck, Lixin Colin Xu, and Bernard Yeung where they argue that while institutions are important for attracting FDI, they are not the only things that are important. Since no one has ever said this, it is easy for them to prove this proposition.
Their starting point is a sense of irritation that the world keeps accusing China of having weak institutions which not only, via special incentives, attract a lot of FDI but also deter domestic investment. But, they say, "standard measures of institutional quality can be problematic for countries undergoing rapid institutional development, and can usefully be augmented by economic track record measures." In short, as Deng Xiao Ping, the father of China's economic reforms is supposed to have cleverly said, that as long as the cat catches mice don't ask what colour it is.
The paper is a marvellous exercise in Vedic debate which often focused on the true nature of cosmic causality. For example, " the law and development literature leads many to believe that a positive relationship exists (between strong institutions and FDI); ... . On the other hand, FDI, compared to domestic investment, might be less affected by inadequate institutions because foreign investors may have better access to capital and may have home authorities' backing in protecting their rights." Well, isn't that what the criticism is?
The authors then go on to discuss the rule of law as a determinant of FDI and say that "both rule of law and a good government track record, as registered by high and stable prior growth, attract FDI." Does this mean that the two are in some ways substitutes? "FDI inflows are not reliably related to limits on executive power or freedom from corruption." Then comes an extraordinary explanation, if not defence, of corruption. " for foreign firms with bargaining power, high bribes can be offset with tax or regulatory privileges."
"Our primary research question is whether or not China is attracting too much FDI given its well known institutional inadequacies and questionable government quality. Our answer is "probably not." We estimate a cross-country FDI model that explains inward FDI using measures of the strength of constraints on executive power along with more general measures of government quality and track record at fostering growth plus controls for general development levels and key country characteristics."
The authors have constructed a model that seeks to capture what has happened in China since the reforms of 1993 -- the ones that also contained the massive 30 per cent devaluation of the Yuan which led, four years later, to the East Asian crisis. The main finding from this is that "China scores only a little worse in rule of law than other countries at similar income levels." Thus the only way in which China is an exception is that it performs better in economic terms.
The main lesson therefore is the Dengian one: as long as you give the foreign devil what he wants -- profit -- other things like good and strong institutions matter for a great deal less. In India, the question that corresponds to Deng's one about cats is aam khane se matlab hai ki guthli ginnay se? (Are you interested in eating the mangoes or in counting the pips?)
Finally, there is this breathtaking proposition: China is a democracy because the Communist party there has factions. "the Chinese Communist Party is far from homogeneous. It has numerous factions... . This internal competition resembles...the factional disputes in, for example, Japan's Liberal Democratic Party." Serves the Japanese right, I guess.
Institutions and Foreign Investment: China versus the World, NBER Working Paper No. 13435, September 2007