Legal Traditions and Foreign Ownership Modes: Evidence from China

• Date: 01 December 2015
• DOI: http://doi.org/10.1111/asej.12079
• Published date: 01 December 2015

Legal Traditions and Foreign Ownership

Modes: Evidence from China*

Quanlin Gu, Shaoan Huang and Yupeng Shi

Received 22 May 2011; Accepted 26 July 2015

Using census data gathered in 2001, the present paper examines how legal tradi-

tions influence foreign investors’ choice of ownership modes in China. The study

finds that, first, investors from economies sharing the same legal origin with China

tend to select ownership modes with a relatively high level of foreign control. That

is, such foreign direct investment (FDI) firms are more likely to be wholly owned

enterprises or joint ventures with relatively large foreign shares. Second, similari-

ties in legal enforcement between China and the home economies correlate posi-

tively with high foreign control. Third, the effects of legal traditions on ownership

modes are relatively weak for new entrants compared to their forerunners, probably

owing to the continuous improvement in China’s business and law institutions.

Keywords: foreign direct investment. foreign ownership modes, legal origin.

JEL classification codes: F21, K22, K40.

doi: 10.1111/asej.12079

I. Introduction

For investors seeking to enter a foreign country, the first and perhaps the most

critical decision they have to make is to choose an appropriate ownership mode.

That is, do they establish a wholly-owned enterprise (WOE) or enter a partnership

with local investors in the form of a joint venture (JV)? In the latter case, what

ownership share is preferred? Obviously, ownership modes are important because

they determine foreign investors’ control over the firm, profit shares, and the

investment risk involved.

The choice of ownership mode has been the subject of many previous studies

(e.g. Anderson and Gatignon, 1986; Gatignon and Anderson, 1988; Pan, 1996;

*Gu: Guanghua School of Management, Peking University, 5 Yiheyuan Road Haidian District,

Beijing 100871, China. Huang: Center for Economic Research, Shandong University, and School of

Economics, Central University of Finance and Economics, 27 Shanda Nanlu, Jinan, Shandong

250100, China. Shi (corresponding author): School of Economics, Central University of Finance and

Economics, China. Address: 39 South College Road, Haidian District, Beijing 100081, China. Email:

shiyupeng@pku.edu.cn. The authors would like to thank seminar participants at Central University of

Finance and Economics and Shangdong University for comments on earlier versions of the manu-

script. The authors also thank Jian Zhang, Qiong Zhang and the anonymous referee for comments and

suggestions. Yupeng Shi gratefully acknowledges the financial support from the Major Project of the

National Social Science Foundation (14ZDB120), the Major Project of the Chinese Ministry of

Education (14JZD019) and the Program for Innovation Research in Central University of Finance and

Economics.

bs_bs_banner

Asian Economic Journal 2015, Vol. 29 No. 4, 365–384 365

© 2015 East Asian Economic Association and Wiley Publishing Asia Pty Ltd

Tse et al., 1997; Zhao and Zhu, 1998; Pan and Tse, 2000; Luo, 2001; Wei et al.,

2005). A topic of special interest in the recent literature is the relationship

between the institutional environment and ownership modes (e.g. Tse et al., 1997;

Dikova and Witteloostuijn, 2007). However, to the best of our knowledge, no

research exists that empirically tests whether legal traditions (defined as the

systematic differences in laws and legal institutions) have effects on the owner-

ship modes. Our paper provides a first attempt at addressing this lacuna in the

literature. We use census data that include all foreign firms active in China at the

end of 2001 to examine whether legal traditions influence the ownership modes of

foreign investors. We find that investors from countries with the same legal origin

(German law) as China preferred ownership modes with a relatively higher level

of control. In other words, they were more inclined to set up WOE or JV with

relatively large foreign ownership shares.

Legal enforcement, as measured by the degree of judiciary independence and

the tendency to settle disputes privately, is found to have a similar impact on

ownership modes. However, the effects of legal traditions and enforcement on

ownership modes are weaker for new entrants. This result probably is obtained

because of the continuous improvement in China’s business and law institutions

during the period of transition.

The rest of this paper is organized as follows. The next section (Section II)

provides a brief overview of the related literature and highlights how legal

traditions are classified and how legal enforcement is measured. Section III

describes the data and the patterns of ownership in firms with foreign direct

investment (FDI) in China. Section IV discusses the hypotheses to be tested and

the specification of the regression model. Section V reports the main results and

Section VI concludes.

II. Measures of Legal Traditions

Both theoretical and empirical studies suggest that institutional differences

between home and host countries have important effects on investors’ choice of

ownership modes (Tse et al., 1997; Li and Rugman, 2007; Chiao et al., 2010).

However, the institutions studied in the literature generally refer to either a very

general concept of economic, legal and social institutions, or their specific

aspects, such as political risk, government intervention and intellectual property

rights (Henisz, 2000; Luo, 2001; Yiu and Makino, 2002; An et al., 2008). To the

best of our knowledge, few published studies quantitatively investigate the impact

of country-specific legal traditions on FDI and little consensus has emerged so far.

However, legal traditions imply different levels of legal protection for foreign

investors, and are often posited to have crucial impacts on various economic

phenomena, such as growth, regulation and financial market performance

(Mahoney, 2001; Beck and Levine, 2002; La Porta et al., 2008).

In the comparative law literature, countries’ legal systems are often classified

by their legal origins. For example, early studies such as Wigmore (1928) identify

ASIAN ECONOMIC JOURNAL 366

© 2015 East Asian Economic Association and Wiley Publishing Asia Pty Ltd