China's Commitment Problem and the Limits of Financial Market Development

Abstract

The Chinese government has the power to arbitrarily reform financial markets. This creates a commitment problem whereby good reforms do not have strong long-term protections and can be arbitrarily reversed. Using the Chinese initial public offering (IPO) market, we demonstrate that the inability to protect good reforms incurs large costs that outweigh the perceived benefits. The re-introduction of price controls in the IPO market in 2014 has led to lower price efficiency, a wealth transfer of over RMB 1.3 trillion (USD 203 billion), and capital misallocation.

Keywords: Credible Commitment, China, Financial Development, IPO Market, Underpricing

JEL Classification: G12, G28, G38, O16, P21