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The neglected other side of politics-3October 15, 2004
[ 1 | 2 | 3 ]
Dear Readers: there was too much interesting material for me to cover in one post, even a long one. So I'm continuing on the topic of national regulations and incentives to run corporations transparently. Initially I started in on the paper "Why do countries matter ...?" (PDF) and found its sources so interesting I felt driven to examine those as well.
As for the initial paper: the authors used a research technique I had never heard of before, which combines the use of mathematical Modeling of incentives (where the principals seek to maximize some function) and an empirical test—one whose parameters are determined by the mathematical modeling. The empirical test includes a regression of nationality on firm characteristics [p.27], to test for p. Then, they analyze the prediction that firms with a greater demand for external finance are
firms that will adopt more constraining governance practices. The study is a very good study in how to analyze a policy matter rigorously; there are few caveats that aren't examined.
The target of this analysis is private expropriation—the ability of a single major shareholder to loot a firm that has many shareholders. Naturally, if the main shareholder owns most of the shares there's little point in looting the firm. Likewise, if the country is notoriously corrupt there is little opportunity to loot anyone, since shareholders will tend to be reluctant to put their money into a domestic firm; hence, capital flight. In that case, there may even be something I like to call, "capital boomerang," where investors of a developing country export capital to a US- or EU-based firm that owns a subsidiary in their country. While the capital flowing out returns to the country of origin, control and supervision are by foreigners. Believe it or not, a gigantic share of services exports for the USA is 3rd-party capital boomerang.
It's impossible to know how much is actually expropriated. In theory, a brilliant white-collar criminal could plunder huge amounts from a superbly transparent company, while horribly opaque companies with atrocious corporate citizenship could ruin their main investors. However, it is possible to rate companies on investor protection and disclosure, and compare these to the firm's known characteristics. Naturally, financial analysts have long established opportunity costs imposed by corruption; the sufferers are, of course, potential middle managers and workers, taxpayers and consumers.
Why would a national government countenance corruption? Why not impose strict disclosure requirements and enforce them? Obviously, part of the reason is that even countries with ostensibly democratic governments can be bribed into inaction. Financial and fiduciary regulation is a tedious business; most voters can't be expected to monitor their legislators' votes in parliament for due diligence. So legislators can run on promises of reform, then pass ineffectual bills that do nothing for managerial probity.
Another reason is the countervailing consideration that countries with internationally-exposed capital markets—just the sort that Doidge, Karolyi, and Stulz recommend—are vulnerable to sudden, undeserved capital flight. Capital flight from Asian markets was damaging to Singapore and Taiwan (where corporate governance was excellent) as well as to Korea and Indonesia (where it was not). There is also a strong historical record that countries require industrial protection in order to develop past a certain level1; exceptions exist, but they involved extraordinary levels of business transparency (Austria and Belgium in the 19th century).
Some will find this difficult to stomach: most "developed" countries achieved breakthrough industrial accumulation under conditions of open capital markets and protected goods markets; the most protected industrializing market of all time was that of the UK (to 1825), which makes Jefferson's embargo on British goods seem a little more understandable. Yet protectionism usually conflicts with transparency: protected markets are usually dirty, and there's grounds for arguing that the general US disregard for state intervention arises from the period 1862-1901, when the scope of the state expanded very abruptly, accompanied by a drastic series of tariff hikes. The composition of the US economy was altered from agriculture to industry, but the economy itself grew slowly because there was so much exploitation and perverse incentive.
Nations therefore have pursued industrialization with an eye to capital controls (which make it harder to raise capital on international markets, because investors fear they'll be unable to divest in the event of disaster) and protected markets (which tend to distort capital allocation to the protected industry; yet capital formation is actually slowed). Investing in protectionist countries is unattractive because there is a major reduction in transparency: national monopolies tend to fail catastrophically. The Gilded-Age USA was an unusual case because of our large internal market; in other cases, such as Japan (1867-1911) and Korea (1953-1997), most capital is raised internally through mobilization of the household sector.
My point, if it isn't obvious yet, is that there are contradictory tendencies at play here. Most constrained optimization problems—this is just such a one—feature an objective function that includes a factor increasing in x and another decreasing in x. The constrained optimum may still be insufficient for economic take-off, in which case there will be evidence favoring free-trade enthusiasts and protectionists. As I've reached my advanced years, I've learned to avoid such consoling conclusions: not only is there no unique path to prosperity for poor countries, there's little reason to expect that path would be followed even if it were known; and even then, it might still be a heartbreak. American industrialization came at a terrible price to the rest of the economy, and on the whole, the late 19th century was stagnant.
Property rights are another problem. It is well-known that respect for property rights stimulates investment and growth [e.g., p.33]. Yet property rights may not deserve respect. In China, of course, the heritage of revolutionary expropriations of property (1949-1954, then 1967-1976) has led to extremely opaque corporate governance; capital formation comes at a terrible price to the household sector (42% of GDP; yet growth rates of 8%—already low for such a high saving rate—fail to discount for the destruction of the undocumented subsistence and cooperative economy). Similarly, in Colombia, property is often accumulated, or was accumulated in living memory, through fraud and terrorism—hence, violent resistance by the displaced bush farmers. In either case, the dispossessed property owners cannot accept the legitimacy of the current property ownership.
The study by Doidge, Karolyi, and Stulz culminates in a conclusion that good investor protection in a country leads to clean corporate governance: A robust analysis, but one based on definitions supplied by the studies it cites. It leaves one wondering what sorts of protections the state can provide. And if those protections are furnished, how to companies improve on them?
La Porta, Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, "Law and Finance" (PDF; hereafter, LLSV, '98) introduce the concept that shares are not merely income streams, but rights that bring legal standing to their owners; investor protections tend to reflect historical transmission of legal traditions, with investor protection strongest in societies with a common law tradition.
Protective measures that can be enshrined in the laws of a country include "one-share-one-vote" rules [p.15]; "anti-director rights", which are There are also creditor rights, which are naturally important when considering bankruptcy; I wrote about this in part 1 of this series. However, LLSV sketch a pretty good outline of how creditor rights vary among different legal regimes [p.20ff]. Curiously, the USA is a legal anomaly in this regard; while common-law countries usually furnish good protection of creditors against managers in the event of financial distress, the USA essentially has a system geared towards keeping firms intact at the expense of the creditors.
In the absence of protections for investors and/or creditors, LLSV speculated that nations might compensate by increased enforcement of laws they do have, or else "bright-line" laws that are easy for judiciary to enforce. Instead, they found the opposite [p.27].
A final form of compensation is concentration of ownership. They established that firm ownership is astonishingly concentrated, even among large firms in the USA (for the 10 most valuable companies, the top 3 shareholders own an average of 20% of the shares; p.30). Asian countries are unusual in having dispersed ownership, which can be deceptive (from my own studies of the keiretsu: in '89 or so, when there were seven major keiretsu in Japan, all seven had stakes in each of the other six through their banking system. But that was only a part of the system of ownership of the companies that dominated the keiretsu, so the top 3 owners in a Japanese kaisha might actually own only 9% of the firm but they have several avatars among the shareholders.
Conclusions suggest that concentration of ownership does seem to serve as a safeguard to investors in countries with poor or limited shareholder protections, as well as poor creditor protection (the US does have meager protections for creditors; but these are offset by the depository insurance system as well as the Federal Reserve system of federal funds. If the junior creditor is not a bank, well... sorry!); The paper concludes that poor investor protection may be a bottleneck, but it does not serve as bar to the formation of efficient companies.
The legal system that fared the worst in international comparisons (besides the defunct Communist regimes, of course) is the French civil law system. I believe this did not prove a barrier to Belgium, France, or Switzerland because these countries also had a French system of conflict resolution. The French system of conflict resolution begins with the idea of concentric coalitions; so that a group of individual who is essential to the universal goal is promoted to an inner coalition. A person who rejects the status quo goes on a partial strike—reduced cooperation, as it were. This is resolved not through one side imposing its will on the other, but through a renegotiation of the coalition. It is a system of resolution that requires long development of social relations to work.
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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