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The neglected other side of politics-2October 14, 2004
[ 1 | 2 | 3 ]
Why do countries matter so much for corporate governance?; part 1 in this series
Another paper from the ECGI (details below) that caught my attention was an analysis of national governments on the honesty and transparency of their own businesses. A startling implication of the paper was that transparency is something that company managers can, in effect, "buy." Moreover, the nationality of a firm appears to be the most important predictor of transparency, rather than firm-characteristics like revenues, asset size, capital structure, and so on. Most interesting of all is the effect of financial globalization on firm governance and the ability to raise finance capital in markets.
One critique of the paper: the language is quite vague, and I feel a bit silly using the phrase "governance" repeatedly, without an explicit definition. As a consequence, it is also very long. Good governance means that the firm is transparent; it maximizes return-on-equity for all shareholders, keeps reliable books, and does not funnel assets to looting functionaries.
Most firms based outside the USA are dominated by a small number of big shareholders (such as the government, or keiretsu in Japan). In countries outside of the OECD, fairly large enterprises can exist mainly to achieve gains for that one shareholder; in some cases, that is the family of a perennial dictator, such as Suharto.
Under crony capitalism, it is possible for large firms to hide profits; the shareholders accept this since they hope their ROE will be increased as the company grows. They also expect hidden profits to be used in the future to furnish capital internally. But the drawback is that management may simply skim revenues; the firm may conceal its financial distress from investors, or cheat customers. The authors treat these activities as "extracting private benefits."
In a country like Canada, it's obvious that extracting private benefits is a calamity for shareholders; there's nothing to be had from opaque managers. That's because the private benefits would come at the expense of the other shareholders. In a country like Romania, the shareholders or their directors may enjoy real benefits by "scamming" corrupt government officials or banks. In order to test theoretical benefits of scamming those not in the inner management of the firm, the authors used a constrained optimization model accompanied by surveys. In contrast, the principle benefit to be gotten from clean, transparent management is ease in raising venture capital.
Doidge, Karolyi, and Stulz measure transparency in different ways. One form of transparency is country-wide investor protection: the composition of laws, and enforcement of those laws, in order to prevent fraud against shareholders (expressed as p). Another form of investor protection is firm-specific (q). They developed a utility function for the main shareholder (S) that increases if the cost of raising equity capital falls, but also increases if it's possible to extract a lot of private benefits from other investors. Put another way, if it is possible to launch an industrial powerhouse through legitimate means, that's a bigger windfall than if the main shareholder instead bilks a share of the capital raised—at great expense—from shareholders.
As with the previous article I examined for this series, the researchers first developed a rich mathematical model, tested it to examine what predictions they wanted to test, and then did an empirical regression using scores for transparency. They established that financial globalization did create incentives for firms to increase q (i.e., to spend more on firm-specific investor protection)—a significant benefit of financial globalization; but is it large enough to offset the CGD trap that afflicts developing nations? (Evidently the chief beneficiaries are secondary shareholders in the 3rd world, followed by primary shareholders, then potential workers in the 3rd world).
[...]
To test our hypotheses, we require data on firm and country characteristics. Firm-level data for sales growth, total assets, ownership, cash holdings, and SIC (Standard Industrial Classification) codes are from Thomson Financial’s Worldscope database. [...]
Finally, we use a number of country-level variables in our analysis. The indices of antidirector rights, rule of law, and risk of expropriation are measures of shareholder rights, enforcement, and property rights obtained from La Porta, Lopez-de-Silanes, Shleifer and Vishny (PDF—hereafter, LLSV, 1998—JRM).. Incidentally, I read the CLSA survey, which is fascinating—the business press at its best. They found that, even for very large firms, the top 25% ranked (for CG) had returns three times greater than the average. That's pretty astonishing, considering there were all those other firm characteristics. It also tends to validate the charge that the severe depression that struck Indonesia and other East Asian countries in '97-98 was indeed consistent with corrupt management. As it happens, I was familiar with many of the bottom-ranked firms. The shares of the cleanest firms in the survey performed exceptionally well, yet price:earnings ratios showed no connection to CG scores; I suspect this is because many of the bottom-ranked firms had huge institutional owners or, in the case of the Russian firms, shareholders expected to capture windfalls in the future from the firm's corrupt behavior—and these expectations did not noticeably subside over the survey period.
(To be continued)
(Alternative POV's): Kevin C.W. Chen, Zhihong Chen, K.C. John Wei, "Disclosure, Corporate Governance, and the Cost of Equity Capital in Emerging Markets" (PDF), June '04;
Matthew S Brown, Katten Muchin, Zavis Rosenman, "The ratings game: corporate governance ratings and why you should care" (PDF); mid-2004;
CLSA Report (Amar Gill, CFA), "Saints & Sinners: who's got religion?" (PDF; 244 pp.), April '01; this is the CSLA study that Doidge, Karolyi, and Stulz used to perform their research.
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