Text 2 Eastern European Securities

Pre-reading tasks

1. Suggest a purpose for reading the text.

2. What can the text be about? Give your own predictions.

3. Do you agree that a big smoothly functioning market for capital needs protecting investors from mischief?

If you want a big, smoothly functioning market for capital, you have to protect investors from mischief. For any emerging economy trying to turn foreign and domestic savings into productive assets, that ought to be an obvious conclusion.

Anybody who doubted the lesson could consult a stack of papers from a research team led by Harvard University's Andrei Shleifer and the University of Chicago's Robert Vishny. Over the past five years, the two have studied the link between investor protection - notably, measures to entrench the rights of minority shareholders, or to require disclosure of corporate information – and growth in financial markets. The numbers make it plain there is indeed a link, but did effective regulation promote financial development, or was it the other way round?

To establish the direction of causation, the researchers needed to find something that affects the extent of investor protection but that is not affected by big, deep capital markets. They settled on legal tradition. Countries with regulatory codes descended from English common law tend to have stronger investor protection than countries with civil-law traditions founded on Roman law; presumably, on the other hand, the extent of modern financial development cannot have affected the historical legal tradition. So the share of investor protection that can be traced to a country's legal tradition - and it is usually a big share - is likely to be a cause of financial growth.

These investigations shed an interesting light on recent changes in Eastern Europe's regulatory regimes. Most of the transitional economies had French- and German-inspired legal systems before communism. When the iron curtain fell, they had a chance to make a fresh start. The most ambitious reformers began to adopt American-style regulations derived from English common law. That process has culminated in Poland's new company law, which came into effect at the beginning of this year.

One of the new law's important provisions is that each share in a public company may carry only one vote. Under the old commercial code of 1934, which remained in force under communism, preferred shares carried up to five votes. Small groups of investors could control firms in which they owned just small stakes; cross-dealings between firms controlled this way could be used to siphon off the wealth of minority shareholders.

Poland's reforms have spawned a derivatives market that last year traded more index futures than Finland, Norway or Portugal. Russia is trying to get into the act by reforming its own derivatives trading, with America's Commodities Futures Trading Commission (the Securities and Exchange Commission's little sister) as an adviser and model. Even in Eastern Europe's most promising regulatory systems, enforcement remains a problem. The courts move ponderously, and judges often lack a sure grasp of the new laws. As a result, legal protection of investors does not yet always mean effective protection of investors.