18 Pages Posted: 29 Oct 1998
As a result of the Asian crisis, relationship-based systems are now under attack for being inefficient and corrupt. Yet, till recently, they were proposed as an alternative form of capitalism to the arm's length Anglo-Saxon system. What went wrong? This paper suggests that relationship-based systems work well when contracts are poorly enforced and capital scarce. Power relationships substitute for contracts, and can achieve better outcomes than a primitive contractual system. But a relationship-based system suppresses the price system and the signals it provides. As a result, relationship-based systems can misallocate capital when presented with large external capital inflows. Since the external capital comes from arm's length investors who typically have little contractual rights or power in a relationship system, and since these investors are rationally aware of the potential for misallocation, they rationally choose to maintain control over borrowers by keeping their claims short term. Thus, the contact between the two systems creates a fragile hybrid, which while mutually beneficial to relationship borrowers and arm's length investors in normal times, is excessively prone to shocks. The paper suggests that while there may be some short term benefits for these economies to revert to the pure relationship-based system, in the long run they will be held back unless they have the greater disclosure, contract enforcement, and competition of the arm's length system. The current Asian crisis may be the most opportune moment for these economies to effect the transition between systems.
JEL Classification: G2, G3
Suggested Citation: Suggested Citation
Rajan, Raghuram G. and Zingales, Luigi, Which Capitalism? Lessons from the East Asian Crisis. Journal of Applied Corporate Finance, Vol. 11, No. 3, Fall 1998. Available at SSRN: https://ssrn.com/abstract=137550 or http://dx.doi.org/10.2139/ssrn.137550
By Ross Levine