Does Enforcement of Intellectual Property Rights Matter in China ...

enforcement raises the costs of imitation and infringement. Consistent with the model in Ueda
(2004), better protection of IP rights will also punish lenders/investors who steal ideas of
innovations, and thus give the firms more confidence in disclosing confidential information to
potential external fund providers.
If better IP rights enforcement could help high tech firms to reduce risks of appropriation by
competitors and resolve the problem of information asymmetry, high tech firms should be able to
receive more outside debt financing in provinces with better IP rights enforcement (Hypothesis 1).
Because these are unlisted companies, new equity could only come from existing shareholders. In
the pecking order of financing preferences, asking current shareholders for fresh capital infusion is
ranked below debt. Thus, we expect that having greater ability to acquire external debt under better
IP rights enforcement should alleviate the need to obtain new equity contributions from existing
shareholders. We propose that better IP rights enforcement reduces the amount of new external
equity raised (Corollary 1).
2.4 The effect of IP rights enforcement on informal financing
China’s formal financial system is large but still underdeveloped; it is mainly controlled by the
four largest state-owned banks. Most of the bank credits are issued to companies in the state-owned
sectors. Although firms in the private sectors have played a critical role in China’s economic
growth, they face substantial barriers to obtain bank credits. As shown in Allen, Qian and Qian
(2005), Chinese firms in private sectors raise only about 10% of total financing from banks, while
state-owned sectors depend more on banks for financing (more than 25% of total financing). These
numbers show that even in the state-owned sectors, bank loans are still not the main source of
financing. Thus, we have a financing aspect of the China puzzle: how could firms finance growth
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