Financial Globalization, Corporate Governance, And Eastern Europe

Financial Globalization, Corporate Governance, and Eastern Europe René M. Stulz

Is the financial world flat?  Since end of World War II, dramatic reduction in barriers to international investment.

 Neo-classical model predicts a flat world for finance:

Extensive risk-sharing across countries and reduction in the role of countries.

 Lucas (1990) argues that since marginal productivity

of capital is higher in emerging markets, capital should flow to emerging markets form developed markets.

 What do we see? A world that is not flat.

Neo-classical world upside down?

Why is the financial world not flat? 

With weak governance, the return from investing does not accrue fully to the providers of capital because of what I call the twin agency problems.



Agency problem at the firm level: Corporate insiders consume private benefits.



Agency problem at the state level: State rulers consume private benefits.

Implications of twin agency problems 

With the twin agency problems, the financial world is not flat.



The twin agency problems lead to ownership concentration.



Therefore, countries where the twin agency problems are important cannot take full advantage of financial globalization.

Roadmap 

The twin agency problems.



Implications for financial globalization.



Eastern Europe.



Conclusion.

The Model Date 1

Date 0

Private benefits Entrepreneur starts firm

Sells equity to public

Entrepreneur does not start firm

Becomes portfolio investor

State expropriation Liquidating dividend

Portfolio payoff

The First Twin:

Agency Problems with Corporate Insiders  Corporate insiders consume private benefits – Planes, easy life, outright theft

 Deadweight cost of private benefits is higher in countries with better investor protection

 Ex post incentives to extract private benefits fall as the insiders’ stake in the firm grows

 More co-investment is optimal when investor protection is weaker

The Second Twin:

Agency Problems with State Rulers 

Extract private benefits also – Redistributive taxes, confiscate assets, require bribes



Managerial entrenchment limits expropriation by state rulers



Firms with professional managers and atomistic shareholders are inefficient when problem is serious

Twin Agency Problems 

Problems interact with one another



Empirically, low expropriation risk is a necessary condition for diffuse ownership



Family control of firms is prevalent in all countries with moderate or high risk of state expropriation

The value of cash

Ownership concentration and financial globalization 

Financial globalization reduces the cost of capital.



With ownership concentration, a firm can take advantage of a reduction in the cost of capital only to the extent that insiders can co-invest.



Hence, the impact of financial globalization is lower when ownership is concentrated.

The neo-classical world

Cost

Mar

The world with the twin agency problems

Cost

Cos in a

Macroeconomic implications 

Home bias.



Savings-investment correlation.



Consumption correlation across countries.



Financial market development.



Economic growth.

Eastern Europe 

How good is governance?



Use World Bank indicators and compare to similar income countries as well as to Western countries.

Overall (Percentile rank, 0-100)

Governance indicator: Overall

100 90 80 70 60 50 40 30 20 10 0

Eastern Europe

Income Category Average Western Countries Average (Europe, US, Canada) 1996

1998

2000 Year

2002

2004

Rule of Law (Percentile rank, 0-100)

Governance indicator: Rule of law 100 90 80 70 60 50 40 30 20 10 0

Eastern Europe

Income Category Average Western Countries Average (Europe, US, Canada) 1996

1998

2000 Year

2002

2004

Control of Corruption (Percentile rank, 0-100)

Governance indicator: Corruption 100 90 80 70 60 50 40 30 20 10 0

Eastern Europe

Income Category Average Western Countries Average (Europe, US, Canada) 1996

1998

2000 Year

2002

2004

Implication 

From the theory, we expect concentrated ownership.



Source of data is Worldscope.



Alternative approaches also show that ownership is concentrated in Eastern Europe.

Ownership concentration in Eastern Europe Closely-Held Shares (% ), 2002 90.0 Closely-Held Shares (%)

80.0 70.0 60.0 50.0 EW

40.0

VW

30.0 20.0 10.0 0.0 Eastern Europe Czech Rep

Eastern Europe Hungary

Eastern Europe Poland

Eastern Europe Turkey

World Median

Western Europe Median

US

Ownership concentration through time Czech Republic

Hungary

Poland

Turkey

All

90.0

Closely-held shares (%)

80.0 70.0 60.0 50.0 40.0 30.0 20.0 1989

1991

1993

1995

1997

1999

2001

2003

2005

What about alternative ways to control agency problems? 

Doidge, Karolyi and Stulz show that country characteristics explain most of the firm-level variation in governance.



Use CSLA rating for firm-level governance in Eastern Europe. Other firm-level governance ratings generally used do not rate firms in Eastern Europe.

Average CSLA Corporate Goverance Ratings 0

Peru

South Africa

Mexico

Singapore

Argentina

Chile

Hong Kong

Brazil

Colombia

Taiwan

Malaysia

70

India

60

Thailand

Hungary

Czech Republic

Philippines

China

Turkey

South Korea

Indonesia

Poland

Pakistan

Russia

CSLA ratings

80

Mean Median

50

40

30

20

10

Firm valuations 

Expect low firm valuations.



Data on Tobin’s q from Doidge, Karolyi, and Stulz.



Data from Worldscope.

Tobin’s Q in 2004 Source: Doidge, Karolyi and Stulz (2005) 1.8 1.6

Tobin's Q

1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 Hungary

Czech Republic

Poland

Turkey

Avg of non-US firms

Financial development 

The analysis implies that the problems documented so far are accompanied by low financial development.



Data from IMF.

Financial Development in Eastern Europe 2.00 1.80 1.60 1.40 Ratio

1.20 1.00 0.80 0.60 0.40 0.20 0.00 World

European Union

Stock Market Cap / GDP

United States

Emerging market countries

Public Debt / GDP

Emerging European coutries

Bank Assets / GDP

Foreign investor participation 

Expect low foreign investor participation.



Data from U.S. Treasury International Capital System (TIC) for U.S. investors.

U.S. portfolio holdings in Eastern Europe US owership as a percentage of total domestic market capitalization 0.18 0.16

US Ownership

0.14 0.12 0.10 0.08 2001

0.06

2003

0.04 0.02 0.00 Czech Republic

Hungary

Poland

Turkey

Median across Western European countries

Median across all countries

Problems with governance reform 

Insiders have paid for their private benefits, so reform that restricts consumption of private benefits takes money away from them.



Hence, governance reform must be designed so that it benefits insiders as well for it to happen.



Insiders can gain because they can sell their stake and benefit from diversification.



Importance of financial openness as a solution.

Conclusion  The financial world is not flat because of the twin agency problems.  Poor governance leads to ownership concentration which prevents countries from taking advantage of financial globalization.

 Evidence for Eastern Europe consistent with the theory: Poor

governance, high ownership concentration, low firm valuation, low financial development, and low participation by foreign investors.

 Improvements in governance would make it possible for Eastern

Europe to benefit more from financial globalization, but such improvements have to be made in a way that benefits incumbents as well for them to be successful.