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Rapid development of the domestic private sector in communist China and Vietnam has been offered as evidence against a large literature that claims a solid legal infrastructure is required for the financial sector to contribute to economic development. One component of the counterargument holds that relationship-based lending has served as an effective substitute for legal institutions. In this article, we challenge this assertion with empirical findings that show bank credit allocation that relies heavily on “connections” undermines the impact of finance on investment growth. Our data come from Vietnam, where—like China—the private sector and financial sector are expanding dramatically but rule of law has not kept pace. Although Vietnam's banking sector is in transition toward a healthier system, it still allocates a disproportionate share of credit to “connected” enterprises in less competitive regions. We find that political connections, in particular, are an ineffective tool for channeling bank credit to the most profitable investors. Using a two-stage empirical approach, we find evidence that banks place greater value on connections than performance and that the firms with greater access to bank loans are no more profitable than firms without them. By some measures, connected firms are even significantly less profitable. We conclude by demonstrating that the most profitable investors in Vietnam have forgone the formal banking system, preferring to finance their activities out of reinvested earnings or informal loans (JEL G21, G28, G30, O12, K11).
Malesky et al. (Fri,) studied this question.