COPYRIGHT 1998 Frank Cass & Company Ltd. (UK)

I. INTRODUCTION

In the recent debate on economic performance in advanced countries, trust has emerged as a critical issue. Trust-based relations between economic agents have been seen as part of the competitive advantage of manufacturing enterprises in Germany, Japan and parts of Italy during the 1970s and 1980s [Sako, 1992; Putnam, 1993; Lane and Bachmann, 1996]. Similarly, in debates on developing countries the question of trust is receiving increasing attention. In 1996, the World Bank set up a group to study the relevance of social capital, of which trust is a central component, and a paper by Knack and Keefer [1996] explored the link between levels of trust and economic growth. Trust is emerging as the new 'missing factor' that explains why some countries or regions develop rapidly and others lag behind.

In this journal, the most significant contribution to this debate was the two-part study, 'Behind the Market Stage Where Real Societies Exist' by Jean-Philippe Platteau [1994a; 1994b]. This study, and Moore's [1994] critique, provide a critical reference point for discussions of trust in developing countries. They review the social and institutional conditions upon which effective markets rest and put the question of trust at the centre of the development debate.

This article seeks to extend this debate conceptually and empirically. Section II discusses the meaning of trust and prepares the conceptual ground. We first distinguish between trust and sanctions and observe how the two operate in conjunction. While this is implicit in some of the literature, trust and sanctions are often viewed as antithetical. The key is that they are additive: sanctions limit the risks involved in trust. Both sanctions and mast can be seen to operate at three different levels: the macro, the meso and the micro. Second, we suggest that trust operates at two levels: in the ordering of the relationships required for basic market transactions, and in the relationships which sustain the co-operation seen in industrial supply chains and clusters. Thus, we distinguish between minimal and extended trust. Platteau's study focused solely on minimal trust.

The empirical discussion opens with section III which addresses the question of minimal trust in the transition economies of the Former Soviet Union: why is it lacking and why is it so hard to construct? The Former Soviet Union is chosen because it illustrates the importance of trust for establishing the basic conditions for a market economy. In section IV we examine how extended trust grows or can be made to grow in supply chains and clusters in developing countries. Trade liberalisation exposes industries in developing countries to increased competitive pressures. Firms can respond to these pressures by restructuring their links with other firms, but this requires increased trust. We do not suggest that trust-based relations always improve performance, and we explore some of the limitations on the development of mast-based relations. However, we are concerned with how trust grows (or fails to grow) and how it can be promoted.

Throughout the article, we focus solely on relationships between firms, regarding these as critical for economic development, and agreeing with Moore [1994] that trust in such relationships has features which are distinct from consumer-business relations.(1)

II. THE PRODUCTION OF TRUST

The issue of trust arises because economic transactions involve risk. In perfect competition, risk is ruled out by the assumptions of perfect information and candid rationality. The first assumes that agents are fully and costlessly informed about all aspects of transactions. This not only rules out risks from fraud, but also risks arising from uncertainties about future events. The second assumes that people pursue self-interest, but only in an honest way, which rules out fraud and opportunism. In the real world, however, agents face risks when they enter exchange. They have limited capacity to collect, store and process information, and these processes themselves incur costs. There are limits to how far contingencies can be predicted and incorporated into contracts, and also limits to the extent to which relationships can be monitored. At the same time, agents may be less than candid - they may use guile to pursue self interest. This opens up risks associated not only with fraud and misrepresentation, but also with transaction-specific investments. Even when one's partners in transactions are not fraudulent, upfront investments and unanticipated events open up the possibility of opportunistic behaviour.

If these types of risks cannot be handled effectively, many exchanges that would be of benefit to both parties will not materialise because of the risks involved. Where risk is uncontrolled, agents resort to spot transactions, but these are limited and ineffective:

When firms feel uncertain about the reliability of a client or supplier, they fall back on a 'flea market' mode of transacting: inspect the good on the spot, pay cash and walk away with it. This way of conducting business is unwieldy for all but the smallest of firms. To operate with any degree of predictability, firms must be able to take and place orders, arrange the future delivery of goods and services, and seek and provide warranty [Fafchamps, 1996: 444].

There are two main ways of dealing with risk - sanctions and trust. The first accepts that the 'partner' is both self-interested and will act with guile, but controls the risk by creating incentives and penalties which make it unattractive for the partner to renege on an agreement. Dixit and Nalebuff [1991: ix] define strategic thinking as 'the art of outdoing an adversary, knowing that the adversary is trying to do the same to you'. While many of the illustrations of such interactions are taken from sport and war, similar arguments are used in the analysis of business relationships. In other words, it is important to be on one's guard when entering exchange, not because all potential partners are opportunistic, but because some might be: 'It is not necessary that all agents be regarded as opportunistic in identical degree. It suffices that those who are less opportunistic than others are difficult to ascertain ex ante and that, even among the less opportunistic, most have their price' [Williamson, 1979: 234].

The second approach to the problem of opportunism suggests that, contrary to Williamson's assertion, it is possible to distinguish opportunists from non-opportunists. The many available definitions of trust have two core elements: an agent's acceptance of risk arising from the actions of others, and the expectation that the 'partner' will not take advantage of the opportunities opened up by the agent's acceptance of risk. This is captured by Baier's definition of trust as 'accepted vulnerability to another's possible but not expected ill will (or lack of good will) toward one' [Baier, 1986: 235].(2) In other words, even when partners could gain from opportunistic behaviour, they will refrain from doing so. This is the distinctive feature of relationships based on trust: the risks taken expose the agent to possible losses which are greater than the advantage being sought. In Luhmann's words, 'trust is only possible in a situation where the possible damage is greater than the advantage you seek' [Luhmann, 1988: 98]. The reason for accepting this extra risk is the grounded belief that the partner will not behave opportunistically.(3) If there are no grounds for this belief, the situation is one of 'blind trust', which is not considered here.

Both sanctions and trust, in their different ways, increase the predictability of the partner in a transaction. When successful, this predictability becomes a strong expectation which assumes a 'taken for granted' character and greatly facilitates exchange. In some cases, sanctions and trust can substitute for each other: the existence of cheap and effective sanctions allows firms to economise on trust, and where trust exists, firms can reduce the expense and complications of arranging sanctions. Similarly, where contracts cannot be enforced, firms have to build up personalised trust relationships to sustain even simple transactions [Fafchamps, 1996]. However, most economic relationships involve a combination of both sanctions and trust. The existence of sanctions that contain risk may encourage companies to take greater, trust-based risks, as will be seen below.

Sanctions and trust both operate at three different levels, as shown in Table 1. Macro-level or impersonal sanctions are those which are potentially applicable to all inter-firm transactions. Meso-level sanctions are applicable to particular sub-sets of enterprises, often applied at the sectoral level. Micro-level sanctions are applied to particular enterprises and depend upon a relationship between particular agents.

First, the most obvious sanctions in inter-firm relationships are those written into contractual provisions, which state the terms of the exchange and provide for legal redress. Such contractual provisions are standard business practice. Secondly, sanctions can be applied at the meso level. The regulatory activities of sectoral bodies are particularly important here. In the banking and finance sector, for example, adherence to procedural norms designed to protect clients may be monitored by regulatory agencies. In some countries, such as Germany, sectoral bodies play an important role in [TABULAR DATA FOR TABLE 1 OMITTED] regulating relationships between enterprises [Lane and Bachmann, 1996]. At the same time, sanctions can be enforced informally within business networks. The most obvious example would be the loss of reputation consequent on misbehaviour. The dire consequences of defaulting are often stressed in the literature on business minorities. Entrepreneurs in these groups risk not only losing their business partners but also social rejection from their group:

Those who flaunt the rules are ostracised socially, and punished economically ... The accepted rules of behaviour are widely agreed upon in the community, and are enforced by a network of sanctions, both positive and negative, both economic and non-economic. The system is well suited to minimising both transactions costs as well as the risk of opportunistic behaviour [Mead, 1984: 1101].

Thirdly, micro-level sanctions can be applied to specific exchange relationships. The one most cited in the literature is the consequence of opportunism on the future income from a business relationship. Relationships which benefit both parties are in the interest of both parties to sustain: 'The business relation itself is the creditor's best collateral' [Fafchamps, 1996: 444]. Additional security can be gained by the use of 'hostages' - self-enforcing agreements which penalise opportunistic behaviour.(4)

Sanctions are a central part of business relations, but they have their limits. At the macro level, contracts can be expensive to draw up and enforce, even when non-compliance is easy to establish. Moreover, the use of tough, enforceable contracts to penalise non-compliance may only deter potential partners from entering exchange, particularly if these contracts do not recognise legitimate reasons for compliance failures [Fafchamps, 1996: 428]. At the meso level, the deterrent effect of loss of reputation only works when a 'community of exchange' exists. Similarly, sectoral regulation by sectoral associations or legally established regulators is uneven in its coverage and effectiveness. Finally, at the micro-level the decision by an aggrieved party to discontinue a relationship has the consequence of sacrificing its own future income stream as well as that of the partner.

Reliance on sanctions is most effective when the exchange relationship is clearly delimited, the level of uncertainty is low, and enforcement is easy. In other circumstances, the use of sanctions is much less effective. Firstly, if the exchange is subject to unpredictable contingencies (climatic, political or economic disruption, etc.), then it becomes difficult and costly to write contracts foreseeing many possible eventualities. Secondly, in cases of marked information asymmetries, one of the partners may be unable to monitor the transaction and assess its terms. Just such a situation is described by Kollock [1994], who discusses the development of trust-based trading strategies in the rubber industry. The quality of rubber at the time of sale is known to the seller, but not to the buyer. Therefore, the buyer is subject to unknown risk. Thirdly, as inter-firm transactions become more complex, macro-sanctions and macro-trust become less appropriate for regulating relationships. Many inter-firm transactions involve multi-layered relationships which are not susceptible to legal redress. The problem of opportunism is not simply one of fraud or theft, but rather one of commitment to the relationship and the mutually acceptable resolution of unforeseeable problems. The uncertainty of economic life means that companies constantly face these adaptations.

Reliance on sanctions alone would severely limit the development of exchange relations. The perception that markets function with difficulty if they are a Hobbesian 'war of all against all' leads to the question of 'market order'. This was discussed in this journal by Platteau [1994a; 1994b], who posed the question 'How, in a world characterised by imperfect information and opportunism is it possible to contain risk and establish efficient exchange?' After analysing the sub-optimal outcomes of many games based on the pursuit of self-interest using guile, Platteau concludes that calculative self-interest is not enough to support efficient exchange: 'if individuals do not trust others to fulfil their terms of an agreement, they will not wish to enter exchanges with one another - except in so far as exchanges are constituted by spot transactions - and economic specialisation will not develop' [Platteau, 1994a: 545-6].

He argues that opportunism has to be constrained by moral norms and that generalised morality is an essential ingredient for effective markets. This ensures that there is a prevalence of honest people in the population, a general expectation that others will be trustworthy and a tendency for breaches of trust to be sanctioned. Such a morality will ensure the survival of honest trading even in the presence of some dishonest players. Without such a generalised morality, markets will function poorly.

This argument has been challenged by Moore [1994], who places greater emphasis on the role of institutional and interpersonal reputation mechanisms in sustaining trade. The argument that 'market order can be produced incrementally through the experience of market transactions themselves' [Moore, 1994: 824] rests on the efficacy of reputation effects. Cheating in business transactions does not pay; it may bring an immediate gain but ruins reputation and hence further business:

I am optimistic that the social relations that underlie effective markets (in 'advanced' societies) may be created more rapidly than he [Platteau] implies, and created through the market process itself through the social ties and trust built up through the experience of market transactions - rather than through the more pervasive changes in social norms on which Platteau focuses. I am more optimistic than Platteau about the scope for the market to create and sustain its own social order [Moore, 1994: 818].

In other words, the predictability of inter-firm relationships could be increased even when a radical change in underlying morality was not expected. We agree with much of Moore's argument, but we attempt to develop it further by:

nd trust and considering the limitations of both and the inter-relationship between them; and

* introducing the distinction between the minimal trust required for simple exchange and the extended trust which supports more complex inter-firm relationships.

It was argued above that while sanctions attempt to change the payoffs to exchange partners so that betrayal becomes unattractive, trust involves the accepted vulnerability to another's possible but not expected ill will. But if the world does contain opportunists, how can one locate trustworthy partners for transactions? This is the central question in trust. We will now consider the three levels of trust and the relationship between sanctions and trust.

In her work on the production of trust, Zucker [1986] identifies three forms of trust production: institution-based, characteristic-based and process-based. As shown in Table 1, trust can be provided through institutional means at the macro level. Zucker argues that in the United States the combination of waves of immigration, a high level of geographical mobility and a high rate of enterprise births and death undermined systems of transactions based on ethnicity, reputation and direct experience. Rules were needed to make markets more orderly, and new, institutionalised forms of trust production arose [Zucker, 1986: 69-85]. An institutionalised system of market regulation grew up, which provided agents with information about potential partners.

Institutions can offer basic information about other agents. Companies regularly seek bank references when entering into exchange with new partners. This gives them some information about past performance, which agents take as a guide to likely future behaviour. Certification, too, can tell us something about potential partners. In the business world, the development of certification in the areas of quality (ISO 9000) and environmental performance (ISO 14000) has enhanced the extent to which companies can feel confident about partners about whom they have limited direct information.(5)

At the meso-level, characteristic-based trust is one form of trust production. According to Zucker, it arises 'where trust is tied to a person, depending on characteristics such as family background or ethnicity' [1986: 53]. In this case, the trustworthiness of an individual is defined by membership of a group whom the agent considers trustworthy. The agent might also be a member of the group, and this identity establishes certain common meanings or assumptions about exchange. However, preferences for transacting with a specific group need not be based on identity. Meso-level trust can also be established through reputation: companies and individuals can acquire reputations for probity and technical competence which are known beyond those with whom they have immediate contact.(6) The difference between reputation as a sanction and reputation as a basis for trust is that the former defines the penalty for not living up to the reputation, whereas the latter is seen to define the inherent attributes of the firm concerned.(7)

Finally, micro-level trust is based on first hand experience of exchange or co-operation with particular enterprises. Zucker calls it process-based trust. It is particularly important for repeated inter-firm transactions, where enterprises can build up a relationship over a period of time. The development of this form of trust involves two key elements. First, repeated interactions allow partners to understand each other's motives and priorities. One of the weaknesses of calculative and game-theoretical approaches to inter-organisational transactions is that they assume an ability to calculate the payoffs to partners of different courses of action. However, agents are boundedly rational and face different resource constraints. They have to make choices in uncertain conditions. Therefore, it is not possible to predict how a partner will behave merely through the calculation of alternative streams of benefits. Part of the process of deciding how far to trust involves finding out in practice about the strategies adopted by one's partners.(8) Secondly, the experience of the trading relationship indicates the underlying trustworthiness of potential partners. Luhmann argues that a deepening of trust involves a learning process, and that 'such learning processes are only complete when the person to be trusted has had opportunities to betray that trust and has not used them' [1979: 45]. This reasoning takes the past as a guide to the future, assuming the continuity of personality which is the foundation for social life.

These processes are well illustrated by Menkhoff's discussion of the development of trust-based relations among Chinese traders in Singapore [1992]. Trust is important because contractual sanctions are ineffective (as in the case of much trade between small firms), and trade is characterised by uncertainty. To start a business in Singapore involves establishing credibility. Menkhoff describes how new traders have to slowly build up a track record of trustworthiness. As they do so, the risks wholesalers are prepared to take increase [1992: 269].(9) Wholesalers will not trust just anyone, even someone of Chinese origin living in Singapore. Clearly, community and business sanctions are not enough - otherwise the wholesalers would extend credit to the client rapidly. For the same reason, the loss of future business cannot be assumed to be a deterrent until the trading strategy of the client is understood. Credit is not extended easily: trust has to be 'earned' by the client. Similar processes are evident in the case of overseas trade. Traders like to meet their overseas partners and to build up their relationship slowly. In this way, they learn who can be trusted to supply on time and who can be trusted to pay. Those who can be trusted are offered transactions involving higher potential losses.

We have set out three levels of sanctions and trust. How do sanctions and trust change as firms move from simple transactions towards more complex interactions and interdependencies? Many inter-firm transactions have clearly delimited scope and clear criteria for compliance by both parties. The key element of the transaction concerns keeping to explicit agreements. In many cases, the possible recourse to macro-level sanctions is sufficient to sustain the exchange. The main sanction is the law. When firms have the security of this basic sanction, they may be in a position to extend some degree of trust, because the level of exposure to risk is limited by effective sanction. They can take risks based on institutional trust. Firms proceed as if contractual obligations will be fulfilled, and in most cases they are. We characterise this level of trust as 'minimal trust'. It is the minimal basis for an effective market economy. When the institutional foundation for minimal trust is not in place, firms have to resort to meso- and micro-sanctions and trust to support exchange. The latter is far from impossible, as the experiences of long-distance trade and trade under situations of political instability have shown, but in such conditions, trade will remain restricted. The problems arising from the absence of minimal trust in the transition economies and the ways in which such trust might be established will be considered in the next section.

'Extended trust' develops when firms create more complex interactions and inter-dependencies. Interdependence is nothing new but the recent literature on supply chains, clusters and networks suggests a degree of interlocking which can only function when relations between firms are sustained by more than minimal trust. The need for extended trust is clearest where unanticipated contingencies are to be dealt with through cooperation. Trust is no longer limited to the expectation that explicit promises will be fulfilled: the partners make commitments in the expectation that the other side is committed to developing the relationship. This transition is often characterised as a shift towards trust-based relationships, but sanctions continue to have a role in limiting exposure to risk. For example, Lane and Bachmann's argue that the legal and institutional frameworks existing in Germany reduce risk and uncertainty and make trust-based relationships possible [1996: 6-10]. First, they point to the role of law in regulating relations between enterprises. In Britain, the lack of regulation of terms of payment increases uncertainty for suppliers by raising their exposure to risk and also produces tensions that prevent close relationships developing. In Germany, terms of payment are regulated by law and institutional arrangements. This provides a stable relationship on which relations can develop [Lane and Bachmann, 1996: 35-6]. Second, Trade Associations in Germany play a role in standardising relations in particular sectors - raising predictability and providing a clear framework for enterprise relations. These institutions and practices establish the foundations for long-term relationships based on trust.

Formal institutions are not the only basis for sanctions supporting extended trust. Moore [1994] has emphasised the role of reputation effects within tightly knit trading communities. Here, the essential ingredient is the widespread communication of information about the performance and reliability of agents.(11) Sanctions reduce the risks associated with trust. At the same time, the widespread use of trust in relationships creates a strong need for sanctions to contain the risks involved. It can be argued that one of the great strengths of industrial districts (agglomerations of enterprises in the same sector characterised by a high degree of specialisation and cooperation between firms) is precisely that their social embeddedness makes sanctions so powerful. Defection involves not only loss of business but also social sanction.

The existence of macro- and meso-level sanctions helps to contain risk. As a result, they can facilitate the development of process-based, extended trust between enterprises. The slow process of incremental increases in risk and the establishment of mutual understanding can be accelerated through the control of risks.

To summarise, the reduction of uncertainty in relationships greatly extends the range of viable transactions. Both sanction and trust have a role in this process. It is possible to distinguish between the minimal trust required to sustain straightforward transactions, and the extended trust involved in more complex relationships. The former is basically concerned with the fulfillment of explicit promises, while the latter is concerned with the more diffuse commitments which arise in collaborative arrangements between enterprises. Both types of trust are complemented by sanctions. In practice, sanctions and trust are bound up together, and their influence and operation are difficult to distinguish.

The remainder of this article uses these categories to analyse two distinct situations. Section III focuses on transition economies, because this is where the lack of minimal trust has emerged as a major obstacle to developing effective market relations. We ask why such trust is lacking and why it is so difficult to construct it. Section IV then concentrates on industry in developing countries and analyses attempts to raise its competitiveness by building extended trust. In the literature on supply chains and industrial districts, trust-based relationships are seen as providing a significant competitive advantage, and yet the conditions under which trust can be established are poorly understood.

III. MINIMAL TRUST FOR EFFECTIVE MARKETS IN TRANSITION ECONOMIES

A major problem facing the transition economies is the scarcity, or absence, of the minimal trust required to facilitate transactions. We consider it the key obstacle to the establishment of an effective market economy in these countries. The purpose of this section is twofold: first to explain why minimal trust is lacking in some of the transition economies and to relate this to the question of sanctions; and second, to map out the ways in which a combination of sanctions and trust could be developed. The literature one can draw upon for this purpose is scarce, but the main issues seem to emerge clearly.

In the transition economies of the Former Soviet Union and Eastern Europe, the production of trust is a particularly urgent issue; so much so that the Polish sociologist Sztompka [1995] has entitled his work 'Trust: the missing resource of post-communist society'. He concludes that the lack of trust is pervasive and that reversing this is very difficult. Sztompka [1993] traces the historical reasons for the distrust, concluding that most of the current problems are due to a deficiency of cultural and civilisational resources. One of the legacies of the communist system and its command economy is what he calls 'civilisational incompetence'. According to Sztompka, in the previous command economy, 'to "beat the system", to outwit the authorities, to evade public regulations, rules, laws [became] one of the widely recognised virtues' [1993: 90]. In other words, Sztompka suggests that the moral norms necessary for an effective market economy have been eroded under communism. In a later article Sztompka [1995] further argues that this erosion of moral norms continued after the fall of communism. He discusses current reasons for the pervasive distrust such as the ineffectiveness of law enforcement agencies and the frequent changes in regulations and economic policies since 1989.

It is against this history that we need to examine the problems of constructing sanctions and trust in the ex-Soviet republics. While trust is widely recognised as central to the establishment of an effective market economy, research on transition economies offers little for a focus on trust. One can, however, delineate from the wider literature an optimistic and a pessimistic view. As these views are presented, key issues concerning trust and sanctions will unfold.

The pessimistic view, of which Sztompka is a clear example, emphasises the importance of moral norms and history. It has much in common with the position taken by Platteau (see above). Platteau argues not only that generalised morality is essential for sustaining market exchange, but also that such moral norms are rooted in a long historical process:

norms of generalised morality - perhaps contrary to moral norms in small groups - cannot be easily expected to evolve spontaneously when they are needed to make economic exchanges viable. Ultimately, the cultural endowment of a society plays a determining role in shaping its specific growth trajectory, and history therefore matters [Platteau, 1994a: 533-4].

Moore's critique of this view depends on the greater role he accords to reputation mechanisms. However, when great ruptures in the economic order occur, this reputation mechanism is less effective - and it is hard to imagine a greater rupture than the transition from a communist centrally planned economy to a market economy with private ownership of the means of production. The problem and how to solve it can be examined through a discussion of the three levels of sanctions and trust (Table 1).

At the micro-level, the key sanction is the (fear of) loss of future benefits from the relationship. This does not seem to operate. Analyses of the transition experience in Russia show that opportunism tends to be rewarded: 'conditions continue to make it more rational for entrepreneurs to renege on commitments and re-negotiate at every step in the process' [Sheppard, 1995: 187]. In order to explain this, it is worth recalling a lesson from game theory: co-operation becomes more likely when a game is repeated and a final round is not fixed in advance. The transition to a new order is a unique occurrence and in the course of that transition many one-off transactions take place. Wagener [1994: 647] points out that in such a situation it pays the individual to be ruthless; enormous and lasting gains can be made at the expense of others. Hence, even minimal trust is difficult to achieve in the transition phase.

Economic volatility means that transactions are frequently not repeated. Even when they might be, the possibility of large, one-off gains makes the behaviour of partners unpredictable. Where longer-term relationships between agents do emerge, the lack of clear 'rules of the game' means that such alliances might be directed as much at distorting markets and gaining disloyal advantages over other groups as at improving economic efficiency. These processes have been little analysed.

A study by Kharkhordin and Gerber, which examines the social ties among Russian industrialists, shows that the old ties, dating from the days of central planning, can be the basis of new effective networks 'pervaded by a sense of loyalty, mutual help and joint responsibility' [Kharkhordin and Gerber, 1994: 1076]. In these networks, trust was not granted indiscriminately but restricted to a group of suppliers who both provided critical inputs and had maintained social ties. The significance of these ties became apparent in 1993 when prepayment had become an almost universal requirement in industrial exchanges and deliveries within the network were still frequently shipped without it. Members of the group also helped each other to select new suppliers [1078]. These findings suggest that such networks can promote more effective exchange in the hostile climate, but it is worth remembering that such ties have also been criticised as obstructing the rebuilding of the economy, recreating monopolies and generating windfall gains. In other words, the dynamics of trust-based networks depend very much on the operation of the larger economy.

Economic volatility also undermines the use of reputation as a sanction or as a basis for trust. A survey of private sector manufacturing in St Petersburg concludes: 'Given the degree of uncertainty in the economy, it is rational for most entrepreneurs to focus on quick profits which obviates the need to develop a reputation. A pervasive lack of trust impedes the development of sophisticated business relationships and narrows the scope of private activity' [Webster, 1995: 211]. Presumably social sanctions are unlikely to play a major role, because former social networks are destroyed or being transformed. In a rapidly changing economy, not only are the opportunists able to make large killings, but the trustworthy have little chance to establish their reputation. The old networks collapse, and new ones take time to develop. Let us stress, however, that very little is known about such meso-level trust in transition economies.

The weakness of micro- and meso-level sanctions and trust inevitably put the focus on the macro level. It is worth remembering that Zucker locates the development of (macro-level) institution-based trust in the history of the United States in the context of rapid changes which undermined process-based and characteristic-based trust. At the macro-level, sanctions are provided by contract law and trust is built through certification. Both an effective legal system and institutional-based trust are absent in the ex-Soviet Republics. Let us consider the consequences.

According to the World Bank's Governance and Development, a good legal framework for economic development has five critical elements: '(a) there is a set of rules known in advance; (b) the rules are actually in force; (c) there are mechanisms ensuring application of the rules; (d) conflicts are resolved through binding decisions of an independent judicial body, and (e) there are procedures for amending the rules when they no longer serve their purpose' [World Bank, 1992: 30]. The law supports trust by reducing uncertainty. The smaller the leap into the unknown, the easier it is to make. In this sense, the rule of law eases economic transactions and helps markets to flourish. The urgent need for an effective legal system is a recurring theme in research and policy documents concerned with private sector development in Eastern Europe and Central Asia [Boycko and Shleifer, 1995; Grey and Hendley, 1995; Sheppard, 1995; Webster and Charap. 1995]. While the history of economic development is full of examples of flourishing trade without legal backup [Zucker, 1986: Greif, 1989; Clay, 1996; Moore, 1997], it is hard to see how the transition economies can succeed without the state creating a legal framework in which trust can develop. The bases on which trust developed in capitalist countries are largely absent.

The absence of an effective legal system compounds the problem of creating trust. In the ex-Soviet Republics, the transition to a market economy was not accompanied by clear property rights, contract law and enforcement: 'The result, of course, is that organised crime enters to protect property rights and enforce contracts' [Boycko and Shleifer, 1995:78]. Varese [1994: 230] goes a step further and warns that 'the future of Russia may be in some respect similar to the history of Sicily'. His work on the Russian Mafia is an empirically based account of the consequences of not having clear property rights and contract law:

Economic reforms from 1986 onwards have produced a dramatic increase in the number of property owners and transactions ... which has not been matched by clear property rights legislation and administrative or financial codes of practice. Nor has it been matched by a corresponding ability on the part of the authorities to enforce such legislation as does exist ... As a consequence, fear of losing property and vulnerability to frauds increased and so correspondingly did the demand for protection. An independent supply of potential 'protectors' has also appeared on the scene: an increasing number of dismissed officers and soldiers from the Army, the KGB and the police are looking for jobs and the only skill they possess is physical force. They perfectly qualify as autonomous private suppliers of protection! ... I will argue that in an untrusting world like present day Russia, it is highly rational to buy private protection despite all the collective evils it produces [1994: 231].

The need for effective legal sanctions is undisputed, particularly in view of the weakness of other forms of sanctions. More controversial is what kind of legal system should be put in place.(11) This cannot be discussed here, but is clearly a major issue for research and policy.

While the concern with law and enforcement is a priority, other institutional ways of resolving conflict should not be neglected. Because the law is expensive and cumbersome, mediation services have been developed in USA, Japan and other countries: 'Mediation is cheaper, quicker and conducted in an atmosphere in which the parties' willingness to discuss settlement is not seen as a sign of weakness, thus pre-empting the need to adopt a war posture ... The mediation services fulfil a useful function of restoring "good-will trust" between trading partners before it is too late' [Sako, 1992: 172].

The point of discussing these mechanisms is that their existence makes it easier to trust. Clearly they are not useful for dealing with blatant fraud, but they help to deal with the more common messy situation where both parties cut corners (for fear that the other may also do so). Knowing in advance that arbitration exists makes it easier to leap into the unknown. It would seem that such alternative institutions for dispute resolution are an important complement to legal reform, especially, but not only, in transition economies. The trouble is that little is known about how they work, under what conditions they are effective, whether they work better as public or private self help schemes. From a trust perspective, these are important issues for research and policy.

IV. EXTENDED TRUST FOR INTERNATIONAL COMPETITIVENESS

If the transition economies confront the problem of establishing minimal trust, the processes of liberalisation and globalisation have put issues of extended trust on the agenda for enterprise development. While this agenda is relevant for all countries, we focus here on developing countries.

It is widely accepted that raising competitiveness in such countries requires rebuilding inter-firm relations. Major role models are Japanese supply chains and Italian industrial clusters. Both entail a high degree of inter-firm dependence and appear to involve a high degree of trust. This section examines developing country experiences in rebuilding supply chains and restructuring industrial clusters. Are the new practices based on trust? Where they are, how do trust and sanctions reinforce each other? How is trust constructed? What is the relative importance of the macro, meso and micro levels? While there is advanced country literature which helps to develop the questions further, for the answers we draw primarily on our own recent research.

Trust and Supply Chain Development

In the industrially advanced countries, the past two decades has seen a significant shift in the competitive environment facing enterprises. Enterprises have sought to win customers by competing not only on price, but also on factors such as speed of delivery, product quality and innovation. This has forced changes not only in the internal organisation of firms, but also in inter-firm relationships. Networks of firms and strategic alliances between enterprises have come to be seen as an important source of competitive advantage.

Developing closer and more co-operative relations with suppliers based on trust is now part of international recipe-book for management best practice. With the pressures of liberalisation, ideas of supplier restructuring are spreading rapidly in developing countries. An article in an Indian business magazine described the change taking place in India in the following terms:

[Companies] are reducing the number of their suppliers, sometimes to half the original number. To the few that remain, they are paying their undivided attention, helping them improve their processes, reduce rejections and cost, and so on. Where once the relationship with their suppliers was one of indifference or of unabashed exploitation, it is now one of close co-operation. 'Business partner' is the term that companies now use to describe their suppliers (Business World, 14 June 1995).

The rationale for closer relations is not hard to establish. Helper has characterised the shift in the US auto industry as a movement from 'exit' to 'voice' [Helper, 1993]. In the 'exit' strategy, firms establish arm's length supply relationships with a large number of firms and reduce costs by using the threat of ending the contract. In the 'voice' strategy, companies maintain closer relations with fewer suppliers, offer incentives for long-term commitment and establish dense flows of information in both directions. Innovation gains may also be achieved. The two sides in the arrangement share the gains from increasing efficiency and are in a better position to expand market share.

This type of relationship is often characterised in terms of trust. The advocates of lean production argue that, 'the [Japanese] system replaces a vicious circle of distrust with a virtuous circle of co-operation' [Womack, Jones et al., 1990: 150]. Similarly, Helper puts trust at the centre of the 'voice' relationship: 'A powerful incentive to participate in voice is a share of the joint profits that result from performance improvements. However, since many of the payoffs to voice are long-term and difficult to observe, trust is a prerequisite to making the necessary investments' [Helper, 1993: 151]. These statements argue powerfully in favour of trust-based relationships. However, it is far from clear that they are a panacea for supply problems. Even those, like ourselves, who are optimistic about the potential for the development of relationships based on extended trust must consider in what circumstances such relationships are advantageous and feasible for firms in developing countries.

Trust in supplier relations often involves relationships between larger firms and smaller suppliers. It is easier for the more powerful party in a relationship to be trusting because the smaller firm is usually more vulnerable [Sydow, forthcoming]. Therefore, the key trust question concerns the problem of the vulnerability of the supplier. This can be considered from two perspectives: the provision of institutional or legal sanctions to protect the supplier and the nature of the transactions between firms.

The importance of institutional factors that facilitate the development of trust-based relations between firms was emphasised in section II. Lane and Bachmann [Lane, 1995; Lane and Bachmann, 1996] highlight a number of factors promoting trust between firms in Germany, notably the role of industry associations and legal regulation of terms of payment. However, the authors also point to other factors. The German firms were not competing in price-sensitive market segments, which means that the customers were more concerned with the quality and technical competence of their suppliers rather than low costs. The suppliers had been able to invest in both equipment and labour. As a result, they could develop a broad customer base and not be dependent on one customer.

As yet, little research has been carried out in developing countries on trust in supplier relations. In what follows, we draw on our own work concerned with the attempts to develop trust by a large Indian electrical company.(12) This company faced a problem which is becoming increasingly common. In response to liberalisation, it had changed its competitive strategy and had begun to reorganise its internal processes around the principles of just-in-time and total quality in the latter part of the 1980s. In the early 1990s it began a supplier development policy aimed at improving the quality of components, particularly from its smaller suppliers. The supplier development programme was based on the notion of long-term, partnership relations. What were the key factors influencing the outcome of this programme?

The company wanted radically to change relationships with its suppliers. Hitherto, these had been based predominantly on multiple sourcing and arm's-length relations. Shifting to partnership proved to be complicated. Translating new ideas into practical relationships is not easy. The main risk for the company concerned reliability of quality and delivery, which had become critical factors for gaining market share for many product lines. The risks were greater for the suppliers, many of whom were small. They risked opportunistic behaviour on the part of the customer. The suppliers were promised a long-term future with the company, but they would be required to invest heavily in new capacity and capabilities in the short term. They would be expected to improve quality, make more frequent deliveries and reduce costs. Involvement in joint cost reduction programmes would involve giving the customer access to their plants. The suppliers might well fear opportunistic behaviour from the customer - either by forcing down prices or by passing on their 'secrets' to rival suppliers.

In this context, potential benefits to both parties are threatened by fears of opportunism. How might these be overcome? No effective meso-level institutions were available either to limit risk by setting down norms and regulating behaviour, or to provide technical services which improve the suppliers' capabilities. The small companies received some financial and technical support from various government agencies and sectoral associations, but there was no regulation of inter-firm relationships, and late payment of bills by large customers was a constant problem for suppliers.

In the absence of meso-level regulation, micro-level trust and sanctions assume critical importance. The first question concerns the transition from mistrust to trust. Process-based trust relies on experience, but that experience had been negative for the suppliers. Breaking with the past and establishing new relationships was the customer's goal. At the plant most committed to supplier restructuring, management saw the re-negotiation of supplier contracts as an important element in these efforts, and it offered new contracts with immediate gains for suppliers, including the possibility of making the company pay for parts ordered but later cancelled. Implicit in this contract was a new approach to the issue of late payment. The formalisation of contracts was seen by management as a means of both offering improved contractual safeguards and demonstrating goodwill.

The production of trust remains, nevertheless, slow. The crucial element concerns how firms respond to unforeseen eventualities. The suppliers will only find out how trustworthy the customer is when short-term interests favour betrayal. The rapidly changing economic situation in India increased the risk and unpredictability of relationships. While this might be a reason for developing trust - reducing controllable uncertainties in inter-firm relationships enables companies and their managers to confront these broader uncertainties - the bases for trust can be undermined by such uncertainties, too. The uncontrollable uncertainties increase the level of risk arising from trust.

The long-term security of the suppliers depends in large part on their ability to provide hard-to-find services to their customer - technical competence, knowledge of the company's systems and so on. The key to their security is the penalty to the customer of ending the relationship. Without this, the suppliers are always at risk from an 'exit strategy', or the threat of exit used to drive a hard bargain. At the plant most exposed to cost competition, relations with suppliers remain conflictual. In contrast, more effective efforts at developing suppliers relations are evident at a plant competing on speed of delivery. The suppliers are beginning to play a central role in the plant's competitive strategy, and the customer has to trust the suppliers' competence. However, since many suppliers have only limited technical competence and specialist skills, the basis for developing trust relations broadly across suppliers remains fragile.

To summarise, this case illustrates a number of issues which are central for the discussion of trust in supplier relations in developing countries. On the one hand, the basis for the development of trust is partially in the hands of the partners, and particularly in the hands of the dominant partner. The transformation of relationship requires not only a change in attitude, but also a change in the division of labour between enterprises and a change in competitive strategy. Without such changes, there is little basis on which trust can develop, and talk of trust and partnership will remain just that. On the other hand, the development of trust can be facilitated by the external environment. Macroeconomic uncertainty is an incentive to develop trust, but it also exposes both partners to further risks. The absence of meso-level regulation clearly increases the risks to the weaker partner and has created a legacy of mistrust around late payment. The potential role for government in changing this environment and fostering improvements in relationships between enterprises will be considered at the end of section IV.

Trust in Industrial Clusters

Constructing trust is a process. Above we examined the difficulties facing a company wishing to move from low trust to high trust relations with its suppliers. Now we take a different cut and examine experiences in which firms need to revise the bases on which they trust in order to raise their competitiveness.

The focus here is on industrial clusters in developing countries which are characterised by a particularly high degree of interdependence. Trust sustains the deep interlocking of enterprises often found in such clusters. How is this developed and sustained? This sub-section pays particular attention to the role of socio-cultural ties in helping economic agents to cope with the risk of opportunism. We will show both the importance and the limits of a socio-cultural base for sanctions and trust. This will be done by drawing on the experience of two export oriented clusters, in Brazil and Pakistan. In both, trust was based initially on socio-cultural ties and later on conscious investments in inter-firm relationships. The explanation of how and why this occurred needs to be preceded by some observations on the relevance and organisation of clusters.

The international attention given to clusters of small and medium enterprises was prompted by the Italian experience [Piore and Sabel, 1984; Brusco, 1990]. The relevance of clustering was then explored for other advanced countries [Garofoli, 1992; Pyke and Sengenberger, 1992] and for developing countries [Schmitz, 1989]. More recent research on developing countries suggests that clusters of small and medium enterprises are common in a wide range of sectors and countries [Nadvi and Schmitz, 1994]. The growth experiences of such clusters vary, but they include some notable success stories. For example, Brazil is today a major shoe exporter, a position it owes to a cluster of enterprises in the Sinos Valley in the south of the country. Similarly, a cluster of manufacturers in and near the town of Sialkot is one of the world's two main exporters of stainless steel surgical instruments. Both are cases of fast industrial growth, based on local enterprises which export most of their output to North America or Europe [Schmitz, 1995; Nadvi, 1997].

Such clusters consist of a multitude of formally independent highly specialised enterprises with a high density of transactions among them. They often engage in horizontal and vertical co-operation, even though the precise modalities and incidence of co-operation vary between and within clusters as well as over time. Since mutual dependence is high, the exposure to opportunism is high, particularly so where suppliers make transaction specific investments and final producers rely on suppliers to be able to meet tight schedules and produce high quality. What enables the enterprises to take such risks?

The literature on industrial districts in Italy has a clear proposition on this: it emphasises the embeddedness of enterprises in communities and the socio-cultural ties which facilitate trust and sanctions. Becattini [1990: 38] has defined the industrial district as a 'socio-territorial entity which is characterised by the actual presence of both a community of people and a population of firms in one naturally and historically bounded area'. Dei Ottati, building on Becattini's work, defines the 'social environment of the ideal-type industrial district' in terms of a common culture, frequent face-to-face relations, and 'norms of reciprocity accompanied by relevant social sanctions' [1994: 530].

Recent research on industrial clusters in developing countries confirms that social ties are an important basis for trust and sanctions. However, we suggest that their importance diminishes as clusters grow. This comes out clearly in a case study on shoe manufacturing in the South of Brazil which developed over two and a half decades from a cluster of small enterprises producing only for the local market to one of the world's main exporters of leather shoes. Non-economic ties between the enterprises - clustered in the Sinos Valley - used to play a major role. They exerted pressure to keep commitments and facilitated co-operation, but their importance changed over time. Four phases can be distinguished [Bazan and Schmitz, 1997].

* The first stage was pre-industrial and characterised by the emergence of a strong socio-cultural identity. This was based on common German descent and a shared experience of surviving hardship and isolation through co-operation and mutual help. Social standing in the community depended on participation in co-operative practices, honesty and hard work.

* In the second stage, starting in the 1930/40s, a local shoe industry was established. This was greatly facilitated by the trust and sanctions based on the inherited socio-cultural ties. Knowing each other socially furthered mutual reliance and limited fraud. It also underpinned the collective action which led to the setting up of a shoe fair organisation and of training and technology centres.

* This socially based reputation and trust worked well until the early 1970s when exports began to boom. This marks the beginning of the third stage during which socio-cultural ties weakened and had less of an influence on inter-firm relationships. This seems to have been a result of the speed at which growth and differentiation occurred and of the key role of outsiders, particularly export agents, in this growth process.

* Co-operation in the 1990s has a new basis. Rising quality and delivery standard have induced shoe manufacturers to invest in their relationships with suppliers. This investment is expected to engender commitment and trust. In Zucker's terms, trust shifts from characteristic-based to process-based. It also means that within the cluster, trust has become more selective and is more often constructed bilaterally.

In emphasising this shift we are not suggesting that process-based trust is absent in the early phase or that characteristic-based trust is entirely absent in the later phase. The existence of a local community does not mean that enterprises trust indiscriminately. There are crooks and incompetent people even in high trust communities. But in such clusters a double screening seems to operate. Having the right characteristics (being local and/or of a particular social group) is the first filter. It helps but is not sufficient. The second and more difficult hurdle is to prove honesty and competence. Both filters play a role, the former seems to help the formation of the cluster but the latter carries increasing weight when local firms enter the international market. Attaining international quality and delivery standards rarely leaves much choice: producers rely increasingly on micro-level arrangements. These are, however, backed up by meso-level reputation mechanisms.

Nadvi [1996] comes to similar conclusions in his study of the Pakistani surgical instrument cluster. He explored the role of social networks in regulating inter-firm transactions and facilitating co-operation and found multiple and interwoven social identities in Sialkot. Social ties between producers fall into three categories: caste or 'biradari', family ties, and social networks based on being 'local'. The effectiveness of each of these categories changes with time.

The metal-based surgical instruments industry, by the very nature of its work, has traditionally been associated with the Muslim biradari of 'Lohars' (literally iron smiths). Nadvi concludes that the Lohar biradari was critical in the cluster's initial formation, but has since lost its significance. Today biradari plays little role in inter-firm relations. Family ties (which in the Punjab includes extended family and close friendships) continue to matter. But they do so unevenly: they have facilitated horizontal inter-firm co-operation, but are not key to vertical relationships with subcontractors. Being local, although a weaker social tie compared to family, appeared to have a more important function in strengthening interfirm relations than either biradari or family kinship: 'Social reputation based on 'knowing and being known' locally is a critical part of the social capital of the cluster where the costs of failure or default on the part of an interacting agent can be extremely high' [Nadvi, 1996: 155].

What does 'being local' mean for our discussion on sanctions and trust? Nadvi suggests that local social and business reputations are inseparable. 'The sanction to agents for breaking contracts is a loss of reputation, both economically and socially' [1996: 159]. We are reminded of Becattini's [1990: 38] words that 'in the [industrial] district, unlike in other environments, ... community and firms tend to merge'. Nadvi's fascinating account of the local social embeddedness of export manufacturing does however carry a warning: 'bonds based on localness may be vulnerable as the cluster develops and external actors with whom local manufacturers have no social bonds gain in influence' [1996: 161]. The strategic linkage is with the foreign buyer. The fight for such buyers pitches local manufacturers against each other. And the quality assurances sought by the foreign buyers force local manufacturers to be increasingly selective with their suppliers. As in the case of the Sinos Valley the relevance of local social bonds decreases and trust based on demonstrated economic and technical performance becomes more important.

What do these experiences tell us about the relevance of trust and sanctions at the macro-, meso- and micro-level? It seems that legal redress (macro-level) played little role in regulating inter-firm relationships. There are two reasons. In earlier periods firms could rely on strong meso-level social sanctions and trust. In later periods, when the clusters are competing by making increasingly differentiated products at short notice, seeking legal redress is too clumsy and costly. Coping with unanticipated contingencies is one of the strengths of these clusters.

The main lesson from these clusters is that the meso-level used to be the pillar, but that pillar has begun to crumble and the micro level carries increasing weight. The basis of trust is changing. Let us draw together what the Brazilian and Pakistani cases tell us in this respect. Socio-cultural bonds facilitate trust,(13) but their influence lessens over time; they are eroded by growth, notably the increasing differentiation within the community and the key role of outsiders. Trust has not therefore ceased to be important for the ability to compete. On the contrary, foreign buyers have imposed ever higher standards in product quality, speed of response and reliability which no enterprise can achieve on its own. The question of trust has therefore become more critical, but its foundation is changing from characteristic-based to process-based. The new ties are based on conscious investment in inter-firm relationships. The business partners do not necessarily have to change - but the basis of trust does.(14)

While the clusters on which we focused above were relatively successful in developing sanctions and trust, their trajectory is not the only one. As shown in the final part of this section, trust based practices can be promoted from outside.

Fostering Extended Trust

The responsibility of the state to provide a basic framework for minimal trust is undisputed. Economic development is promoted by stable, clear and enforceable rules. Such rules limit uncertainty and make efficient market transactions possible. There is less agreement about what role the State might play in fostering extended trust. In this sub-section, the potential role of the State in fostering the institutional context in which extended trust can thrive and in directly promoting the formation of networks of co-operating enterprises will be explored.

Enterprises cannot be forced to co-operate with each other, but they can interact with each other in contexts which are propitious to the development of extended trust. The role of macro- and meso-level sanctions and trust in establishing the bases for inter-firm co-operation were discussed in section II. In addition to providing or supporting this framework, the state can play a catalytic role in fostering trust relations in networks of enterprises by bringing firms together in networks. State support for networks has become part of small and medium-sized enterprise promotion policies in a number of countries. The development of trust is central to these initiatives. With trust comes greater willingness to share orders, establishment of new divisions of labour, co-operation in marketing and so forth, which lead to economies of scale and scope and competitive advantages.

Sabel argues that the basis for promoting co-operation lies in increasing interdependence at the sectoral level. Taking the example of network promotion in Pennsylvania, he argues that inter-firm contacts developed in order to diagnose the problems of the firms in a sector led to a change in perceptions of the costs and benefits of co-operation [Sabel, 1992: 239]. Firms came to realise how interdependence between them was increasing and making co-operation both feasible and necessary. Such activities can be extended if, as Lorenz suggests, 'actors in public or quasi-public institutions can play an entrepreneurial role in bringing about new forms of cooperation not so much by acting to enforce obligations but through their ability to persuade and disseminate information about successful innovations' [Lorenz, 1993: 321].

While enterprises may obtain advantages from closer co-operation based on trust, the development of co-operation between SMEs is a costly exercise which faces a severe start-up problem:

These costs, however, can be reduced if co-operation does not rest on continuous re-negotiation but on a mutually shared set of aims and values, and if reciprocal control does not call for recurrent supervision and scrutiny but is guaranteed by mutual trust. Unfortunately, trust, defined as the experience-based expectations of co-operative and benevolent behaviour, cannot be unconditionally presumed. Accordingly, co-operation based on trust has to cope with a severe starting problem [Semlinger, 1995: 274].

The provision of a 'broker' or 'facilitator' appears to be central to the process of kick-starting networks. In the case of Baden-Wurttemberg, for example, the Regional Trade Bureau provided consultants to organise such networks and subsidised their expenses [Semlinger, 1995: 276-7]. The most significant initiative of this kind has been the Danish Network Programme of the early 1990s, which has since been copied, in modified form, in a number of other industrially advanced countries [Humphrey and Schmitz, 1996a].

The development of networks through the use of brokers or facilitators is not limited to Europe or North America. The Proyectos de Fomento (PROFO) programme in Chile is similarly concerned with networks.(15) This programme is based on the idea that small firms can benefit from closer contact and co-operation, and groups of firms in the same locality and sector are targeted. Owners of small businesses are as individualistic and mistrustful of their competitors in Chile as anywhere else, and they are also suspicious of government. Brokers helped to overcome mistrust by facilitating access to state support. This gives the programme credibility and provides a reward for participation. From here, regular meetings of participants help to build up mutual understanding. Out of this contact emerge opportunities for co-operation which would not have been considered before. In effect, the owners begin to know enough about each other to decide to take the risk of co-operation. Once the first steps are taken, the experience of the relationship will determine whether or not trust develops further.

This kind of policy will only work in certain situations. First, such cooperation is more likely to emerge when firms face challenges they cannot easily address on their own. The incentive to co-operate is greatest when enterprises can gain from such factors as economies of information gathering, economies of scale or scope arising from a division of labour, or sharing risks. Conversely, firms in non-competitive markets, or firms whose profit strategy is based on rent-seeking behaviour have much less of an incentive to co-operate. The success of the PROFO programme in Chile can be related to the risk-taking orientation of its entrepreneurs [Montero, 1992] and the export-orientation of Chilean industry, which forced firms to improve their competitiveness. Second, the obstacles facing the promotion of trust depend on both the entrepreneurs involved and the state. The more the entrepreneurs targeted for the programme have a history of co-operation and the more the state is seen as having a legitimate role in sectoral arrangements, the easier it is for such projects to succeed.

Some states and some groups of entrepreneurs favour co-operation more than others. But the pressures of globalisation are increasing the returns to co-operation. Where the response to the pressures of globalisation is organised around flexible response, improved quality and speedier and more reliable delivery, then there is scope for creating competitive advantage through co-operation. In these circumstances, we are optimistic about the potential for promoting inter-firm networks.

V. CONCLUSION

Trust is a neglected resource for economic development. This is now widely recognised. We have taken the debate forward by distinguishing between the minimal trust required for a market economy to work and the extended trust needed for sustaining the interdependence and co-operation between firms seeking to compete in international markets. Both kinds of trust only work if certain sanctions are in place: trust and sanctions are complementary. The problems incurred by the republics of the former Soviet Union make this particularly clear. Effective legal sanctions do not exist and reputation mechanisms are slow to bite because transition implies deep ruptures in the economy. As a result, even minimal trust is hard to construct. Perhaps it is not an exaggeration to suggest that the transition to a market economy will only be complete in these countries once legal enforcement and reputation effects are working.

Competing in international markets requires more than simple market transactions; it tends to entail deep interlocking of producers. The extended trust which sustains such interdependence is in itself dependent on sanctions. We have examined two trajectories of building extended trust. The case of an Indian supply chain shows the difficulty of doing so where competition is price based and the relationship between customer and supplier is asymmetric; in contrast where competition is based on quality and suppliers provide strategic inputs trust-based practices seem to develop. Cases from Brazil and Pakistan underline the relevance of traditional social networks for sanctions and trust but also show that extended trust relies increasingly on economic and technical performance irrespective of social identity. Finally, the study has drawn attention to recent experiences of public agencies in fostering trust. While such experiences remain to be evaluated in detail, they lend support to our optimistic view on the possibility of fostering trust.

John Humphrey and Hubert Schmitz, Institute of Development Studies, University of Sussex. The authors thank David Booth, Mick Moore, Judith Tendler and John Toye for their helpful comments on previous drafts, and Dominic Furlong and Bridget Byrne for their valuable research assistance. Financial assistance from the Department for International Development is gratefully acknowledged. This article draws on their previous paper, 'Trust and Economic Development' [Humphrey and Schmitz, 1996b], but the analysis has been substantially altered and developed.

NOTES

1. The question of trust within firms is not addressed here. For recent contributions, see Fukuyama [1995] and Kramer and Tyler [1996].

2. Cited in Meyerson et al. [1996: 170].

3. It follows that when the predictability of the other's behaviour is based entirely on calculation of the other's self-interest, trust is not involved. Hence, we disagree with the concept of "deterrence-based trust" [Sheppard and Tuchinsky, 1996: 143].

4. For an analysis of private ordering of exchange and the use of hostages, see Williamson [1983].

5. Needless to say, such trust production mechanisms suffer from two defects. First, one must trust the honesty and competence of the endorsing agency. Second, endorsements themselves can be obtained fraudulently. Granovetter [1992] points out that the most effective financial frauds overcome the initial distrust of the victim by having a fraudulent institution to guarantee the transaction.

6. The difference between characteristic-based trust and process-based trust generalised through reputation is not entirely clear-cut. The former has to be sustained by the continued trustworthiness of group members.

7. The reputation of Marks & Spencer for reliability, for example, can be seen in two ways. On the one hand, it is something which provides competitive advantage, and the company would suffer if this were lost. On the other hand, it is an expression of the core values and identity of the company. For a game-theoretic approach to reputation effects see Raub and Weesie [1990].

8. The problem of understanding the trading priorities of partners is particularly important in joint ventures. In the case of the Rover-Honda partnership, the unfriendly divorce was a shock to Honda not because it had miscalculated the potential benefits to Rover's parent of a split, but rather because Honda was working on a different set of business calculations altogether, oriented towards long-term growth, commitment to all stakeholders.

9. For a more extensive discussion of these types of trading relationships see Moore [1997: 313-316]. Similar patterns of the development of trust between traders are illustrated by Kollock's simulation of rubber and rice traders [Kollock, 1994].

10. Such arrangements may also have negative impacts, particularly if strong sanctions inhibit innovation and risk-taking. Strong ties can lead to inflexibility [Grabher, 1993].

11. For contrasting views, see Varese [1994: 241] and Butler [1995: 178]. For a critique of the suitability of Western legal models for developing countries, see Moore [1993].

12. This research was carried out by a research team led by John Humphrey and Raphie Kaplinsky at the Institute of Development Studies. For a more extensive discussion of the trust questions, see Humphrey [forthcoming].

13. Social relations can also have a negative effect on a cluster's growth. According to Knorringa [1996], in the footwear cluster of Agra (India), the economic divisions between producers and traders were heightened by the distinct social castes to which they belonged. While the producers were largely backward caste Hindus (jatavs) and poor Muslims, the traders were forward caste Hindus (banias) and rich Muslims. Knorringa suggests that the antagonistic exchange relationship between producers and traders was reinforced by the distrust and social contempt which the two castes had for each other, thereby weakening the prospects for co-operation.

14. The impression could arise that the change over time affects the whole cluster evenly. It does not. On the contrary, the change works itself out through a process in which some enterprises grow and others decline. The internal differentiation is now well documented - not just for the clusters in Brazil and Pakistan referred to earlier, but also for cases in India, Mexico and even Italy, the land which gave rise to the recent industrial district debate [Knorringa, 1996: Rabellotti, 1997].

15. For further details of the PROFO case, see Dini [1993] and Humphrey and Schmitz [1996a].

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