Quid pro quo

• Published date: 01 February 2023
• Author: Zhiyong Yao,Yao Huang
• Date: 01 February 2023
• DOI: http://doi.org/10.1111/rode.12945

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Quid pro quo

Zhiyong Yao

1

| Yao Huang

2

1

Department of Applied Economics,

School of Management, Fudan

University, Shanghai, People's Republic

of China

2

HKU Business School, The University of

Hong Kong, Pok Fu Lam, Hong Kong

Correspondence

Yao Huang, HKU Business School, The

University of Hong Kong, Pok Fu Lam,

Hong Kong.

Email: yaohuang@connect.hku.hk

Funding information

National Natural Science Foundation of

China, Grant/Award Numbers: 71873036,

72192844

Abstract

This paper attempts to shed some new light on two

puzzles about Chinese economy: Rapid economic

growth despite pandemic corruption; dramatic develop-

ment of the private sector despite ‘ownership discrimi-

nation' in financial resource allocation. In our model,

the productive bribe facilitates the more efficient pri-

vate firm to obtain the scarce financial resource, either

from the bank or from the state-owned enterprise, and

corrects the initial allocation distortion. Meanwhile,

our model also generates the distortionary and the

predatory bribes which hurt the economy.

KEYWORDS

corruption, ownership discrimination, private sector,

productive bribe, state-owned enterprise

JEL CLASSIFICATION

D73, O17, G21

1|INTRODUCTION

Corruption is the abuse of public office for private gain. It is usually regarded as one of the most

pervasive obstacles to economic growth and social development around the world. Many coun-

tries suffering from severe corruption are also accompanied by poor economic performances.

However, despite the serious or even pandemic corruption, China had been growing very fast

during the past decades. Why?

1

Economists have broadly explored the relationship between corruption and its impact on

the economy. The mainstream literature indicates that corruption is highly costly, and thus

slows down the economy. For example, Shleifer and Vishny (1993) point out that the illegality

of corruption and the imperative for secrecy make it much more distortionary and costly than

taxation. Ehrlich and Lui (1999) and Mo (2001) claim that many valuable (human and non-

human) resources have been devoted to seeking corruption rents, which might have been used

Received: 19 April 2021 Revised: 28 April 2022 Accepted: 2 September 2022

DOI: 10.1111/rode.12945

Rev Dev Econ. 2023;27:29–61. wileyonlinelibrary.com/journal/rode © 2022 John Wiley & Sons Ltd. 29

for production or human capital investment. Most empirical evidence supports the slow-down

effect of corruption. For example, Mauro (1995) uses cross-country data to show that corruption

reduces the investment and thus prohibits economic growth. Keefer and Knack (1997) present

that the pervasiveness of corruption may reduce investment and the ability to absorb technolo-

gies from abroad. Li et al. (2000) find that in countries with less equal asset distribution, corrup-

tion is associated with a larger drop in growth rates. Méon and Sekkat (2005) document data in

countries from 1970 to 1998, and show that corruption ‘sands the wheels’of economy.

2

However, China is one of the very corrupted countries (Svensson, 2005),

3

yet China is also

one of the fastest-growing economies during the past four decades. Besides China, other eastern

Asian countries, such as Indonesia, South Korea, Thailand, and others, had grown well despite

high levels of corruption, the so-called ‘East Asian Paradox’(Wedeman, 2002). Not only eastern

Asian countries, but many developed countries had also experienced the coexistence of boom-

ing economy and high corruptions in early years, such as the United States in the late 19th cen-

tury (Glaeser & Goldin, 2006).

Whether corruption, to some extent, ‘greasing economic wheels,’remains controversial.

Most corruptions are purely redistributive or predatory, and thus anti-growth and value-

destroying. Is it possible that under certain situations, corruptions could be productive, pro-

growth, or value-creating? Beginning with Leff (1964) and Huntington (1968), several authors

have suggested that corruption might assist economic growth by greasing the wheels of a rigid

administration. When there are pre-existing policies that have induced distortion, corruption

may bypass the distortion and thus improve welfare (Bardhan, 1997). On the one hand, certain

forms of corruption, like ‘speed money,’will enable individuals to surpass bureaucratic delays

and get ahead in the queue for public services.

4

Lui (1985) shows that, if bribes are regarded as

payments to obtain a better position in the queue, the mechanism becomes a useful auctioning

procedure, and the socially optimal outcome can be obtained. On the other hand, corruption

may also work as ‘piece-rate’pay for government officials, and hence, it improves the provision

of public services (Mo, 2001). Some cross-country empirical works favor the efficiency-

improving effect of corruption. Méon and Weill (2010) find that corruption is less harmful to

efficiency when institutions are less effective, and in countries with extremely ineffective insti-

tutions, corruption may even improve efficiency. Similar results are found by Cai, Fang, and Xu

(2011) in China that, although entertainment and travel costs expenditure overall has a negative

impact on the firm performance, some components of it, such as the bribe to officials for better

government services, bring positive returns to the firm, especially in cities with weaker institu-

tions. The results of Méndez and Sepúlveda (2006) indicate that the growth-maximizing level of

corruption is significantly greater than zero, but when the incidence reaches a high level, cor-

ruption is detrimental.

Besides the coexistence of the rapid economic growth and the serious corruption problem in

China, another puzzle related to Chinese economy is: Why the private sector develops so fast

despite ‘ownership discrimination,’such as facing much more restrictive financial resources

constraints compared to the state sector? It is well known that the private sector is the driving

force behind China's fast-growing economy. It has expanded steadily at a rate of 20% annually

since the beginning of the reform and opening-up in the late 1970s, far above the economy's 8%

average growth for the same period. From almost nothing, the private sector has now accounted

for more than 60% of China's GDP, while the state sector's share has dropped from about 80%

in 1978 to less than 30% (Allen, Qian, & Qian, 2005; Tsai, 2002; Yao, Gu, and Cao, 2019). How-

ever, for example, in the financial area, the government had almost monopolized the financial

resources for most of the reform and open-up period.

5

The majority of the bank loans were

30 YAO AND HUANG

allocated to state-owned enterprises (SOEs), regardless of their unprofitability, leaving compa-

nies in the private sector credit shortage (Ayyagari, Demirgüç-Kunt, & Maksimovic, 2010;

Boyreau-Debray, 2003).

6

However, the misallocation of financial resources did not seem to pro-

hibit the fast growth of the private sector.

The existing yet controversial explanation is the critical role of informal financing in helping

the development of the private sector (Allen et al., 2005; Song, Storesletten, & Zilibotti, 2011).

7

Trade credit is a typical informal financing mechanism (Cunat, 2007; Nilsen, 2002): On the one

hand, the ‘redistribution view’of trade credit argues that bank credit is redistributed via trade

credit by the firms with stronger financial stand to the firms with weaker financial position

(Love, Preve, & Sarria-Allende, 2007). On the other hand, compared with banks, suppliers have

a comparative advantage in getting information about buyers. The better SOEs know about pri-

vate firms (PF), the more efficiently they can liquidate assets (Petersen & Rajan, 1997). Fisman

and Love (2003) empirically show that, in emerging countries with less developed financial

intermediaries, industries that are more dependent on trade credit financing grow relatively

more rapidly. Cull, Xu, and Zhu (2009) investigate how trade credit works in China under the

banking system that is biased towards SOEs, and find that SOEs with access to loans while

poorly performing tend to provide trade credit to other firms. They also point out that the trade

credit alone may not be a major contributor to China's explosive growth.

The two puzzles about Chinese economy, the fast economic growth despite pandemic cor-

ruption, and the dramatic development of the private sector despite ownership discrimination

in formal finance, are internally related and can be studied together. But to our knowledge,

there is a paucity of literature doing so. In this paper, we build up a theoretical model to shed

some new light on the two puzzles. The state-owned bank monopolizes the financial resources,

which both the PF and the SOE apply for to finance their own projects. The SOE has govern-

ment bailout, while the PF does not. But the PF can bribe the banker with kickbacks. When the

SOE obtains the bank loan, its manager can either execute the project, or re-lend it to the PF

for a bribe. Our model generates three types of bribes: Productive, distortionary, and predatory.

The bribe can be productive or efficiency-improving for three reasons. First, it facilitates the

more efficient PF to obtain the financial resources, either from the bank or from the SOE.

Therefore, the allocation distortion in which the inefficient SOE uses the bank loan due to gov-

ernment bailout, is corrected. Second, it fills the gap between the social optimal and the private

optimal, in the sense that without the bribe, the banker, who does not internalize the external-

ity of lending, may idle the fund even though it should be lent out from the social perspective.

Third, it facilitates private information of the SOE to be used in reallocating its bank loan, as

the SOE with a bad project may re-lend its fund to the PF. On the contrary, the bribe is dis-

tortionary if from the social perspective, the banker should idle the fund or lend it to the SOE;

instead, the banker lends it to the PF for large private gain. The bribe can also be predatory or

value-destroying in our model, because knowing that the PF will abuse the fund, the banker or

the SOE manager still offers the loan for a bribe.

We also characterize the respective conditions under which each type of bribe happens. The

bribe tends to be productive when the return of the project is sufficiently high and the bribe is

sufficiently small. The PF will execute the project instead of running away with the loan given

the sizable expected return and small bribe to pay. Bribe makes lending to the PF more attrac-

tive and therefore directs the loan from the inefficient SOE to the efficient PF. Also, the banker

will partially internalize the return of the project via the bribe. The bribe is distortionary when

the bribe becomes greater, as some projects with lower expected return will also be funded and

executed. Predatory bribe happens when the return of the project is low and the bribe is large,

YAO AND HUANG 31