The interest group theory of financial development in China: Openness and the role of interest groups

• Published date: 01 April 2020
• DOI: http://doi.org/10.1111/twec.12828
• Author: Chengsi Zhang,Yueteng Zhu
• Date: 01 April 2020

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wileyonlinelibrary.com/journal/twec World Econ. 2020;43:982–999.

© 2019 John Wiley & Sons Ltd

Received: 9 September 2018

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Revised: 31 March 2019

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Accepted: 18 May 2019

DOI: 10.1111/twec.12828

ORIGINAL ARTICLE

The interest group theory of financial development

in China: Openness and the role of interest groups

ChengsiZhang1

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YuetengZhu2

1School of Finance & China Financial Policy Research Center,Renmin University of China, Beijing, China

2Department of Economics,New York University, New York City, New York

Funding information

This research was funded by the Chinese Ministry of Education (Grant No. 16JJD790057).

KEYWORDS

China, financial development, interest group theory, openness, trade

1

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INTRODUCTION

Both theoretical and empirical research highlights the potentially important nexus between finan-

cial development and economic growth (e.g., Beck, Levine, & Loayza, 2000; Darrat, Elkhal, &

McCallum, 2006; Demetriades & Hussein, 1996; Demirgüç‐Kunt & Maksimovic, 1998; Goodhart,

2004; Guariglia & Poncet, 2008; Levine, 1997, 2003; Shaw, 1973). The frontier of the literature in this

field is shifting towards an examination of the sources of financial development from the perspectives

of financial liberalisation (McKinnon, 1973), legal systems (La Porta, Rafael, Florencio, Andrei, &

Robert, 1997, 1998), government ownership of banks (Andrianova, Demetriades, & Shortland, 2008)

and political stability (Girma & Shortland, 2008).

Another important source of financial development, noted in a growing number of studies, is

openness. The relevant literature has focused mainly on a two‐variable relationship between trade

openness and financial development (Beck, 2002; Braun & Raddatz, 2005; Do & Levchenko, 2004;

Huang & Temple, 2005; Mishkin, 2009; Svaleryd & Vlachos, 2002), financial openness and finan-

cial development (Chinn & Ito, 2006; Huang, 2006; Levine, 2001), and financial openness and trade

openness (Aizenman & Noy, 2009). These studies generally find positive links between the underlying

variables across developed and developing economies.

The seminal work of Rajan and Zingales (2003), however, suggests that findings based on exam-

ination of two‐variable relationships are likely to be incomplete and even misleading. They suggest

that there is an important three‐variable relationship between trade openness, financial openness and

financial development. In particular, they establish that trade openness without financial openness is

unlikely to lead to financial development due to opposition from interest groups.

Baltagi, Demetriades, and Law (2009) address Rajan and Zingales's (2003) interest group the-

ory (hereinafter IGT), using data for both developing and industrialised cou ntries. They find that

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ZHANG ANd ZHU

both trade and fina ncial openness are statistical ly significant determina nts of banking sector de-

velopment and that opening up either trade or finance without opening up the ot her could still

generate gains in financia l development. However, the empirical results in Law (2009) pertaining

to developing countries show that the simultaneous opening up of trade and capital accounts

has a positive impact on financial development, which appears to support Rajan and Zingales's

(2003) IGT. Law (2009) noted that his findings should be interpreted with caution because his

sample countries are from the developing world, where the financial sector is mostly driven by

the banking sector. A recent study by Hauner, Prati, and Bircan (2013), using a sample of 91 coun-

tries, highlighted a failure of IGT: they find that trade openness is a signi ficant leading indicator

of domestic financial development, but there is no consistent evidence of an effect of financial

openness.

The subtle disparities in these studies, using a selection of different countries, imply that the pat-

tern of interactions among trade/financial openness and financial development may differ signifi-

cantly across countries. Although using cross‐country data can enlarge the sample size, it may be

difficult to interpret the corresponding results consistently, and some unique features pertaining to an

individual country may lie undiscovered due to the diversity of historical experiences, cultural norms

and financial contexts in different countries.

Consequently, it is difficult, if not impossible, to define and measure interest groups across

countries with a unified indicator. This may account for the fact that empirical investigations

on IGT in the literature using cross‐country data are all indirect tests in nature. As far as we are

aware, this paper is the first to provide direct tests of IGT. In particular, we quantify the role of

state‐owned enterprises (SOEs) and the intervention of local government in industrial develop-

ment in China to measure interest groups, and we construct models to test the hypothesis of IGT.

By design, the direct tests of IGT provide insights into the role of interest groups in financial

development in China.

The remainder of this paper is organised as follows: Section 2 summarises IGT and its underlying

hypothesis; Section 3 presents the model specification and estimation methods for the direct tests of

IGT; Section 4 describes the data used in the empirical work; Section 5 provides the baseline estima-

tion results, followed by Section 6, which provides robustness analysis; and Section 7 concludes the

paper.

2

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INTEREST GROUP THEORY AND INTEREST GROUPS

IN CHINA

2.1

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Interest group theory and hypothesis

Rajan and Zingales (2003) propose that trade or financial openness alone is unlikely to lead to

financial development. They verify their hypothesis using data for 24 industrialised countries over

the period 1913–99. Rajan and Zingales (2003) put forward IGT as a summary of their research re-

sults. They argue that interest groups, in particular industrial and financial incumbents, frequently

stand to lose from financial development. This is because financial development creates oppor-

tunities for the establishment of new firms, which breeds competition and erodes incumbents'

interests. They suggest that incumbents' opposition to financial development will be weaker when

an economy is open to both trade and finance (capital flows).

This hypothesis of simultaneous openness is reflected in the associated IGT. Therefore, the litera-

ture (e.g., Baltagi et al., 2009; Hauner et al., 2013) highlights the interactive effects of trade and finan-

cial openness on financial development in assessing IGT. At the core of the simultaneous openness