Private guarantees and relational networks

The empirical reality of small business financing in China largely contradicts the current research paradigm on the nexus of formal institutions, finance and growth. Despite weak legal institutions and a rigid banking system, small businesses in China manage to constitute the backbone of the economy through reliance on informal institutional arrangements and nonbank financing. This book explores the structure of small business lending practices in China at the micro-level. An innovative mixed-method approach of experimental economics and nearly 100 qualitative interviews linked to case studies is deployed to understand the institutional underpinnings of lending transactions. The evidence presented highlights how the current research framework on small business financing cannot capture the variety of lending practices found in China, and much less explain their underlying incentive and enforcement mechanisms. The interviews reveal that lenders primarily rely on private enforcement mechanisms outside, or in the shadow of, the law. In doing so, they use network-based soft information to assess creditworthiness, require private guarantors to co-sign loan contracts and align financial transactions with trade and other business transactions. These findings are reinforced by experimental results which indicate that reputational effects, created both in bilateral relationships and in markets in which information on prior repayment behaviour is shared, can indeed ensure contract enforcement in the absence of a third-party enforcer. By showing that alternative governance mechanisms encapsulated in reputation, private relationships and networks are further avenues beyond the law and the legal system in promoting financial transactions, this book expands current research thinking and sets out the direction for further studies on small business financing both in China and in other less developed economies.