People shaking hands in a meeting room.

Unveiling guanxi: resolving contract failure

25 June 2024

The article at a glance

Welcome to ‘guanxi’, a cornerstone of Chinese society where interpersonal connections are tied to career and business success. Guanxi is a double-edged sword: it can facilitate collaborations or fuel corruption. This paper explores guanxi’s dual nature and its role in resolving contract failures when legal systems falter and policy barriers loom.

by Xinyu Hou, CERF Research Associate, Cambridge Judge Business School, University of Cambridge

Xinyu Hou.

Imagine deals made over tea, where trust outweighs contracts, and relationships dictate success. Welcome to ‘guanxi’, a cornerstone of Chinese society where interpersonal connections are tied to career and business success. Guanxi is a double-edged sword: it can facilitate collaborations or fuel corruption. This paper explores guanxi’s dual nature and its role in resolving contract failures when legal systems falter and policy barriers loom.

The double-edged sword of guanxi

Meet Zhang, an entrepreneur with a startup specialising in air purification technology. Bureaucratic delays in obtaining permits threaten his launch. Frustrated by slow formal processes, Zhang turns to his guanxi network. He contacts Li, a fellow townsman with government connections. Over dinner, Zhang explains his project and talks about the town they are both from, earning Li’s trust.

Li leverages his network, securing a meeting with an important official. Thanks to Li’s introduction, Zhang’s application is expedited, and his company quickly gets the permits. At a press conference, Zhang publicly thanks Li, solidifying their relationship for future collaborations

Guanxi versus western networking

Guanxi, meaning relationships or connections, is more than a term in China. It’s a way of life rooted in ancient philosophy emphasising family bonds and social harmony. Both guanxi and networking build interpersonal connections for information, resources, and opportunities, stressing mutual benefit sustained by exchanging favours and support. Trust and reputation are crucial in both contexts.

There are differences: Guanxi, rooted in Confucian culture, emphasises family and long-term reciprocity. Networking focuses on personal achievement and short-term reciprocity. Guanxi involves deep, enduring ties often lasting a lifetime, while networking is more professional and short-term.

Guanxi operates through informal channels, emphasising personal favours and etiquette, whereas networking uses formal avenues, prioritising efficiency and directness. Maintaining guanxi demands significant time and resources with high social risks but potentially substantial long-term rewards. Western networking is less costly, lower-risk, and offers more immediate, specific returns.

Guanxi in resource allocation

In Russia, a similar concept is known as ‘Блат’ (blat), and in India, it is called ‘Sifarish’. But why does guanxi shine in weak institutional environments with low information transparency? Resources are scarce, especially valuable ones. To allocate these scarce resources efficiently, societies need game rules. One common rule is the invisible hand of the market, where the highest bidder secures the resources. Markets minimise waste but only function properly when a robust legal system enforces property and contractual rights – a cornerstone of capitalism.

In environments where trust is scarce and legal frameworks are shaky, alternative game rules prevail. One such rule is ‘the weak are meat, the strong do eat,’ akin to the law of the jungle. A more civilised rule is the rule of seniority and connections, or the rule of guanxi, where resource allocation is determined by social capital rather than physical capital.

Guanxi inevitably has its dark side. It fosters corruption and nepotism, allowing individuals to exploit connections for unqualified positions and gain unfair advantages. This misuse undermines meritocracy, exacerbates inequality, and breeds resentment – precisely what anti-corruption campaigns aim to combat. Whether good or bad, guanxi forms an extremely stable network. It’s reminiscent of the movie The Godfather, where personal favours are essential once you are within the network. Refusing to return a favour can lead to social death. This mutual obligation reinforces and perpetuates the guanxi network, ensuring its continued influence and strength.

Guanxi versus direct transfers: a tale of 2 strategies

In ‘Direct Transfer and Guanxi in Resolving Contract Failure’, guanxi and direct monetary transfers are compared as mechanisms for facilitating transactions. In weak legislative environments, each method has strengths and weaknesses.

Direct Transfers use money to win resources, often as an entry fee or license cost. This approach is simple and clear but can distort incentives. Officials might raise entry barriers to extract more rents, stifling competition and innovation.

Guanxi relies on personal relationships to overcome obstacles, often established by luck. By implementing guanxi, it mitigates the information asymmetry problem and smooths transactions. However, establishing these relationships requires time and effort, often inaccessible to those without existing networks.

Model insights

We use a game theory model to unravel guanxi’s and direct transfers’ complexities. Imagine an emerging market where officials set the rules, and entrepreneurs decide whether to use guanxi, engage in direct transfers, or exit the market entirely, and the official can choose whether to approve
the project.

Key findings

1

Low-quality projects

For low-quality projects, shutting down both guanxi and transfer channels might be best. This prevents
rent-seeking officials from distorting incentives and causing social damages.

2

Good projects

Guanxi is often more effective than direct transfers when it comes to good projects. It aligns officials’ and
entrepreneurs’ interests by addressing information asymmetry and breaking entry barriers.

3

Combined channels

Enhancing self-selection among officials and entrepreneurs by allowing both channels can be beneficial if officials’ interests align with social welfare. Granting pro-social officials more freedom is advantageous since they possess better information. Conversely, if officials are less pro-social, it is preferable to restrict their ability to choose channels for obtaining rents. This idea resonates with the findings in Dybvig and Fu’s (2019) paper, “Tigers and Flies: Conflicts of Interest, Discretion and Expertise in a Hierarchy”, which claims that fighting corruption and imposing stringent constraints are substitutes: enhancing one reduces the effectiveness of the other. Additionally, the paper highlights that combating corruption and training lower-level officials are complements: improving one enhances the value of the other.

Conclusion

Regulation and deregulation, stability, and economic growth are always concerns for policymakers. Conflicts of interest between rule-makers, game players, and society often arise, making it unclear whether less rent-seeking or a blanket ban is beneficial. As we can see, guanxi, which regulates
behaviour and builds trust among officials and entrepreneurs, can be a way of smoothing out transactions. In particular, a pro-social official has more information, setting rules that encourage good behaviour aligns the official’s interests with social welfare, reducing the need for regulation.
Conversely, if a corrupt official has more information, regulation is necessary to prevent harm to society.

This paper suggests that guanxi can be effective in emerging markets but acknowledges that it has limitations. For instance, the dynamics of guanxi and its impact on competition and productivity need further exploration. Future research should investigate the role of competition, the changing use of guanxi and direct transfers over time, and the long-term effects of guanxi cultivation and information reusability.
Understanding these aspects can provide better insights into the balance between regulation and the use of social capital in resource allocation.

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This article was published on

25 June 2024.
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