In general terms, the rule of law describes a fair and formal process by means of which all aspects of society function. Here, arbitration is based on clear rules, which ideally, everyone is aware of. Enforcement of these rules is carried out by means of formal institutions such as courts which have the power to sanction non-compliers. Moreover, the severity of sanctioning must be strong enough to act as a deterrent for potential violators and non-compliers. In order for a country to have
9 Albeit at the expense of one or two oligarchs who had alternative political ambitions.
Page 17
the rule of law, existence of uncorrupt formal institutions is necessary (Charkham, p.5, 2005).
‗The un-rule of law‘ is a term used in the work of Gel‘man (2004) and refers to the dominance of informal institutions and networks which act as a major obstacle to the development of formal institutions and hence the rule of law. In the Russian context, it has been argued, that the dominance of such institutions together with selective application of law and corrupt regulatory bodies present one of the major challenges to the development of corporate governance (Kochetigova et al., 2004).
More specifically, capital markets are directly contingent to the rule of law in that investors‘ confidence will be high in an environment of homogeneously enforced laws. Confidence in formal institutions translates into a significant reduction in the cost of capital (Mueller, 2006) and stimulates the flow of resources to companies.
Moreover, a positive correlation between the rule of law and the size of capital markets has been suggested by a number of prominent studies in the area of corporate governance (La Porta et al., 1997; Modigliani & Perotti 1997; La Porta et al., 1998). In the west, capital markets are relatively developed, in part for the above reason.
Although as far as Russia is concerned, there is no evidence that the size of the financial markets can be affected solely by the improvements of the legal infrastructure (Pistor & Xu, 2005), it is generally agreed that effective regulations are the ‗minimum requirement‘ for the developed capital markets and corporate governance (Roberts, 2004; Pistor & Xu 2002; Pistor & Xu, 2005).
In Russia however, to a large extent, capital markets have been taken out of the equation. The line of causality that has brought about this effect appears unclear.
It has been argued that the root cause of underdeveloped capital markets in Russia has been the rent-seeking motives of government officials and other influential stakeholders who prevent the required development of the legal framework (Modigliani & Perotti, 1997). Some suggested that the swift change from state rule to the market model created the legal vacuum that gave rise to massive self-dealing opportunities and discouraged potential investors (Black et al., 2000). Yet others explain this fact in terms of the genuine evolutional process
Page 18
inherent to and typical of regime change (Shleifer & Treisman, 2005). Regardless of causality, the fact that there is the ‗unrule of law‘ and underdeveloped capital markets is difficult to challenge in modern day Russia. In broader terms, the phenomenon can be attributed to the lack of the capacity of the state and the legacy of the past (Gel'man, 2004). The latter is a constant feature although with time, its effect is likely to erode as ‗new history‘ and culture is created (Helmke &
Levitsky, 2004). The former however, is a more dynamic feature in that it is subject to political forces and the subsequent change in the design and effectiveness of formal institutions10.
It has been suggested that the absence of the rule of law leads to the dominance of informal institutions, which in turn prevent the development of legal infrastructures. This is the case in Russia (Gel'man, 2004; Preobragenskaya &
McGee, 2004). Informal institutions here are likely to create non-contractual enforcement mechanisms which will allow influential actors to collaborate within closed networks, for example cross holdings and private clubs (Modigliani &
Perotti, 1997). These social networks transmit informal rules that fill the gap created by inchoate laws and/or ineffective enforcement. In terms of the latter, informal institutions tend to be characterised by different mechanisms of enforcement in comparison to the formal ones exercised by the police and courts.
‗Informal sanctioning mechanisms are often subtle, hidden and even illegal. They may range from hostile remarks, gossip, ostracism, and other displays of social disapproval to extrajudicial violence‘ (Helmke & Levitsky, 2004, p. 733).
It is critically important to have a deep understanding of the informal rules and associated enforcement mechanisms prior to committing to a contractual relationship with a partner who is conditioned by such an environment. The investigation needs to produce substantial knowledge about the informal arrangements in the Russian business community and the power distribution within it.
The Russian government headed by Putin‘s administration has achieved some success in regaining the capacity of the state (Gel'man, 2004). This, together with
10 This dynamic is most visible when a e politi al la o es to po e . It took less tha a ea of Puti s p eside fo a al st to de la e a i p o e e t i the ou t s usi ess e i o e t.
Page 19
marginal improvements in the legal infrastructure should lead to a redressed balance in favour of the rule of law (Kuznetsov & Kuznetsova, 2003). This fact, assisted by the change in culture and the need to attract foreign capital should lead to the diminishing relevance of the informal institutions. It is expected that these trends will have a positive influence on the development of capital markets and reduce the importance of the informal networks. However, there are active forces opposed to this change. These forces are represented by the desire to retain power on the part of the informal institutions and by corrupted officials resisting institutional reform. A positive trend in the institutional context is likely to happen where the forces behind establishing the rule of law prevail. This would lead to opportunities for the development of the corporate governance system in Russia and bring it in line with western practice. Conversely, if the forces resisting this change prevail, the negative trend may lead to a threat of deterioration.
Hence, it is proposed that opportunity for improvement will be substantiated if corporate governance reforms make formal institutions stronger and informal ones weaker.
Page 20
Figure 2.3: Dynamics of the Institutional Change in Russia Desire to Retain Control
Need for Foreign Capital Changing Culture and Developed Capital Markets
Strong
Opportunity for Improvement Informal Institutions
The Rule of Law
Formal Institutions Opportunity for
Improvement
Weak
Improved Legal Infrastructure Growing Capacity of the State
Corrupt Officials
Page 21