July 5, 2005
Lack of Trust Carries Heavy Toll
By Alex Fak
Would you trust a stranger on a train to look after your bag while you run to the toilet?
Probably not if you're Russian. Seventy percent of people in Russia believe "you can't be too careful in dealing with people," while only a quarter agree that "generally most people can be trusted," according to a poll of 1,500 Russians conducted by the Bashkirova & Partners market research firm last month.
The lack of trust does not just translate into a greater air of suspicion, it also carries a heavy price that weighs down the entire economy.
In the absence of effective mechanisms that enforce contracts and protect property rights -- what economists broadly call "legal institutions" -- trust is left as one of the few informal pillars of economic activity.
Although the costs of mistrust are indirect and hard to quantify, they undeniably take a heavy toll on economic activity. Insecurity forces companies into unprofitable businesses to secure supplies, confines entrepreneurs to dealing only with close partners and deforms the whole structure of the economy.
"When institutions are good, you do not need mutual trust that much" because people have faith that the legal pledges they sign are enforceable, said Yekaterina Zhuravskaya, academic director at Moscow's Center for Economic and Financial Research. "Our institutions, such as the judicial system, are horrible, so we need trust; but trust is nowhere to be found."
That's not to say that Russians are necessarily the most untrusting of people. The World Values Survey, organized by University of Michigan sociologist Ronald Inglehart, puts Russia somewhere in the middle of some 80 nations polled about whether one should trust people in general. Brazilians and Filipinos were the most leery of their compatriots, while Scandinavians and Chinese were the most trusting.
In an Eastern European context, however, Russia was one of only two nations where more people said they did not trust "most people in this country" than said they did, according to a 2004 poll conducted by the Center for the Study of Public Policy at the University of Strathclyde in Glasgow. Bulgaria was the other country.
Institutional uncertainty is also well documented. A World Bank survey published in September found that 75 percent of Russian firms polled complained of "unpredictability of interpretation of laws" -- compared with one-third of companies in China -- and an equal number cited regulatory unpredictability. Two-thirds of Russian firms told the World Bank they had no confidence courts would defend their property rights. The lack of trust inhibits entrepreneurs from committing money to their own businesses. Firms that find their property rights the most secure reinvest 64 percent more money into their businesses than those who are least secure, according to a 2002 survey of 269 Russian firms by three U.S. economists.
Excessive caution also makes doing business more costly. The days when "people would just make deals and run" -- when Russians would only sign short-term contracts -- may be over, said Alexei Dudko, head of the dispute resolution group at Linklaters Moscow law firm. But businesses still have to go great lengths to protect themselves against their partners, he said.
Sometimes companies establish subsidiaries abroad so they can sign contracts under other legal systems, like English law, "because the Russian legal system does not do a good job of regulating things like shareholder agreements," Dudko said.
Russian businessmen are also more likely to use escrow arrangements, in which they transfer money through third parties, Dudko said. In an economy where contracts are more secure, the money spent on such detours could have instead gone to producing a product or delivering a service.
Eric Michailov, a partner at White & Case law firm, said many of his firm's clients preferred to do business with companies they had known for years.
"This will have to change," he said. "As the business base in Russia grows, you're going to have to do deals with people you know less."
But change is coming only slowly. The economists' survey found that 95 percent of companies polled would retain an existing supplier, even if offered a lower price from a newcomer, for fear courts would not enforce a new deal.
Russia's opacity is also responsible for caution. Entrepreneurs who are forced to forge new relationships typically approach potential partners with the thoroughness of a private detective.
"Russian businesses tend to use all possible means to check the background of the other company before signing a contract," said Olga Krysanova, a lawyer at CMS Cameron McKenna.
Large firms that can afford to do so often bypass partners altogether and try to control the whole production chain.
About two-thirds of Russian industrial firms have some sort of vertical integration, said Yevgeny Nadorshin, an economist at Trust brokerage. Although comparable statistics are hard to find, he said that "vertical integration here is much deeper than in developed countries," where cost-saving outsourcing of most noncore activities is common.
Oil firms secure their own distribution channels, buying service stations even when the money could be invested in more profitable core ventures; metal firms mine their own coal, which is necessary for smelting; and all large companies prefer to own their own banks.
"The company knows that documents won't get lost, accounts won't get pilfered," Nadorshin said.
The accumulation of noncore assets leads to further losses, since management time is diverted from core business. Yet firms still feel they have no choice.
"In Russia, if you want to guarantee the loyalty of your partner, buy him," Nadorshin said.