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The Politics of Legal Reform
As more countries make the transition to market economies, the focus of the public policy debate has broadened from macroeconomic stability to the design of institutions that sustain growth. This paper focuses on the development of financial institutions such as banks and stock exchanges, the construction of the legal infrastructure supporting business, and the creation of regulatory mechanisms in line with best world practice. As a result of both the ever-increasing interconnections among financial markets and the waves of international turmoil in the last decade, such as the tequila crisis, the Asian crisis, and the Russian crisis, policymakers are reaching a consensus that the reform of financial institutions is an essential component of reform. Continuing academic research showing that the institutions of corporate governance, in particular law and the quality of its enforcement, are relevant for the development of financial markets and economic growth has backed up this belief.
Despite this consensus and the efforts of several international institutions to promote legal reform, many forces still oppose reform, and little agreement has been reached as to what constitutes feasible legal reforms. This paper first identifies the forces for and against legal reform and reviews their role in episodes of reform. Opponents of reform include managers and families in control of firms, labor, and sometimes politicians themselves. On the other side, the main forces facilitating reform include the opening up of economies and the increased interconnectedness of financial markets, which allows investors from all over the world to vote with their feet when investor protection is not part of the agenda. The primary lesson of this analysis is that the design of reforms needs to reflect [End Page 91] the reality of local forces that may oppose reform and work on mechanisms to appease those interests.
The second goal of the paper is to identify what constitutes feasible legal reforms. There is no one-size-fits-all set of good laws and regulatory mechanisms. More important, rules that work in developed countries might not succeed in developing countries that are struggling with poor judicial systems and lack of rule of law. The divide between developed and developing economies is more pronounced at the level of enforcement than in the laws themselves. Reforming bankruptcy and corporate law must be undertaken in the local enforcement context. Complementary market-based mechanisms and judicial reforms that build further consensus on reform and enforcement are needed for long-term success.
If legal reform is to succeed, the commonly advocated principles of corporate governance in the international community need to be brought down to the local political and judicial realities of each country. A lot of work needs to be done to translate international corporate governance initiatives and principles into clear and enforceable rights for creditors and shareholders. This does not mean that legal reform is country specific, but it does suggest that blindly copying a list of investor rights or transplanting rules is not likely to succeed.
The organization of the paper is as follows. The following section briefly reviews the importance of investor protection and corporate governance for the development of capital markets and economic growth. This section also evaluates whether developing countries and emerging economies have systematically weaker investor protection embedded in their laws and enforcement than do developed countries, that is, whether developing nations face a legal trap. While the results show little evidence of a legal trap, they confirm that disclosure standards and legal enforcement are systematically lower in less developed countries. These facts have two implications for legal reform. First, blindly copying the laws from developed countries and providing rights to creditors and shareholders will not necessarily work in developing countries. Second, reform needs to be in accordance with the local legal system.
The next section of the paper reviews current theory on the politics of legal reform, describing the forces for and against it and what this implies for legal reform. The paper then attempts to translate the challenges imposed by the political and...