Investing in Personal Equity – Part Two – The Rule of Law

After my visits to schools in Sichuan, a meeting with one of the board members of Town and Talent, and conversations with executives at Inventec, I realize how important it will be to address one of the key challenges I mentioned earlier – the rule of law in enforcing property contracts.

To summarize from before, the basic business idea relies on identifying undervalued students and investing in their education and profiting from the economic surplus generated. Since the contract relies on the student’s consent, the idea wouldn’t be able to help younger students since most would argue that both legally and philosophically they wouldn’t be able to give their consent, even though early education seems to be a critical age for education. Thus, the target “consumer” would have to be high school graduates and older (or whatever the legal age of employment consent is).

So why is the rule of law important? Well, imagine that I’ve trained someone to be a computer programmer, but as part of the contract, the programmer needs to work for me for a couple of years below market wages. So instead of getting paid the market wage of $10,000 a year I pay the student $3,000 a year for a few years (which is still an improvement from the $2,000 a year that the student would have made otherwise). But let’s say the student doesn’t want to work for me after I’ve paid for his or her education and that instead, the student ditches me to work for another company that’s willing to pay the market wage. The problem should be obvious – if students don’t work for me but work for other companies but I invested in their education, I am unable to recoup the costs of my investment.

In China, the rule of law and enforcing contracts and property rights is not as strong or as clear as the rule of law in more industrialized and democratic countries like the US. If the rule of law is weak and is unable to uphold contracts, any business investment in an individual’s education will suffer from free rider problems and result in no investment.

Thus, the existence of a strong rule of law and enforcement of property contracts is extremely important in enabling the private market to fund investments in education. But it is also important to note that the private market will be unable to invest in education if the cost of enforcement is also high. If a student breaks a contract and attempts to flee, the expected cost of enforcement must be sufficiently low, otherwise the cost of investment and enforcement might exceed the expected revenue, making the overall investment into the business idea not profitable.

The potentially high transaction costs involved in enforcing contracts is of particular concern in China, where tracking people is extremely difficult. When I asked about the student loan industry in China, Echo, one of the lead engineers at Town and Talent and a graduate from Peking University (the top university in China) told me that the reason students are unable to get loans is because students didn’t repay the loans. Once upon a time the banks tried to give out student loans, but even when students had jobs and could pay off their student loans without a problem, they simply didn’t. Without a way of tracking down the students, banks were unable to recover their loans and the student loan programs shutdown. Maybe if a person’s credit history becomes more important as people look to buy houses on a mortgage and cars on a loan, students might have a greater incentive to repay the loans.

The risk of unenforceable contracts is not insignificant but may be mitigated by 1) the ethos of poor people in Western China 2) the lack of competition in Western China and 3) language barriers. Poor people in Western China, unlike many other areas of China that are famous for criminal and corrupt activity, have a much stronger sense of duty and gratitude and may be less likely to leave the company if they understand how leaving would be unfair to the investors of the project and to future generations of students. There are few, if any tech companies, that exist in Western China, which reduces the risk of students leaving to work for other companies (although students leaving to work for companies in the large cities is still a risk). And the risk of students working on projects directly and bypassing the middleman is mitigated by language and project management barriers.

Despite the challenges, I still think the idea is worth starting and running a pilot (which we’re doing – see image above). And hopefully, after getting some numbers from the pilot (education, project management, capital, and labor costs), the idea can scale.