Predation and Investment Efficiency: Does Corporate Transparency Reduce Growth

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Predation and Investment Efficiency Does
Corporate Transparency Reduce Growth?

• Art Durnev McGill University
• Vihang Errunza McGill University
• Sasha Molchanov Massey University
• Department of Commerce Brown Bag Seminar, April
  18, 2008

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Wall Street Journal Europe, June 29,
2005 Mikhail Khodorkovsky's Yukos, then the
country's largest oil producer, led the industry
to new heights in growth and efficiency by
promoting Western-style transparency, production
technologies and management. Adam Smith In
those unfortunate countries, indeed, where men
are continually afraid of the violence of their
superiors, they frequently bury and conceal a
great part of their capital stock. Effect of
Yukos affair (according to Bill Browder, one of
the harshest critics of Khodorkovsky discussing
transparency of Surgut in 2003-04) the
threat of nationalization is forcing companies to
go backward with their corporate governance.
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Motivation

• Transparency plays a key role in financial
  markets and efficient investment
• Transparency is also important for product
  markets, as customers and suppliers need
  efficient (transparent) contracts to optimise
  profits The customers want to know how well the
  company is doing because they will have to do
  rely on the company in the future for service and
  parts.  
• Numerous rules and regulations introduced aiming
  at improving transparency of financial markets
• Many firms voluntarily choose to exceed minimum
  transparency standards
• Firms set an appropriate level of transparency in
  order to maximize investment efficiency and
  growth

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Motivation

• But what if property rights are not secure? What
  if the probability of government intervention is
  high?
• Firms with high target level of transparency may
  choose to remain opaque
• When the risk of expropriation is high, firms in
  greater need of transparency would allocate
  capital worse and grow slower compared to those
  that do not require high transparency

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Introduction

• Similar argument to that of Rajan and Zingales
  (1998) US markets are the closest in the world
  to being frictionless
• Firms true need for transparency is observed
  in those markets
• Several transparency measures are employed
• Main hypothesis in autocratic and predatory
  countries, firms with higher need for
  transparency experience sub-optimal capital
  allocation
• Our results support the hypothesis

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The Role of Transparency

• Financial markets are characterized by
  information asymmetry
• Transparency is set to alleviate this asymmetry
• Motives for exceeding minimum disclosure
  standards have been widely studied in the
  literature
• Anticipation of market transactions (Barry and
  Brown, 1985, etc.)
• Justification of poor earnings (Warner et al.,
  1988, etc.)
• Signalling by talented managers (Trueman, 1986)

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The Role of Predation

• General notion companies worried about
  government intervention disclose less information
• Han and Wang (1998), Hall and Stammerjohan
  (1997) oil producers underreport profitability
  to decrease tax liability
• Leuz and Oberholzer (2006) firms with political
  connections are less likely to rely on publicly
  traded securities
• Stulz (2006) firms scale down on governance if
  the risk of government expropriation is high
• High degree of government predation affects
  contract enforcement between customers and
  suppliers

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Empirical Specification

• Regressions are similar to those in Rajan and
  Zingales (1998)
• Interaction terms between country-invariant
  transparency measures and the degree of
  predation, country- and industry-fixed effects
  are included
• We are comparing industries within countries

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Transparency Measures

• Financial transparency
• Informational transparency
• Accounting transparency
• Insider transparency
• Structural transparency
• The measures are aggregated using the Principal
  Component Analysis (PCA)

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Informational Transparency

• Intuition if a firms stock return is highly
  correlated with market and industry factors, it
  is less likely to contain firm-specific
  information
• Developed by Morck, Yeung, and Yu (2000)
• Defined as log of one minus the coefficient of
  determination of the following regression

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Accounting Transparency

• Intuition the greater the association between
  the current stock returns and future earnings,
  the more informative the current stock prices
  the result of higher accounting transparency
• Developed by Durnev et al. (2003)
• Defined as the magnitude of coefficients on
  future changes in earnings

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Insider Transparency

• Llorente et al. (2002) the greater the
  information asymmetry between different groups of
  traders, the more likely are the returns to be
  positively autocorrelated
• Defined as C2 in the following regression
• Aggregate financial transparency created using PCA

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Structural Transparency

• Measure of the need for efficient economic
  contracts between supplier and customer
  industries
• Blanchard and Kremer (1997), Levchenko (2007)
  need for transparent contracts is larger if an
  industry uses multiple inputs from various
  suppliers
• Defined as one minus the Herfindahl index of
  input industry shares
• Joint financial and structural transparency
  created using PCA

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Investment Efficiency and Growth

• Wugler (2000) efficient capital allocation
  involves increase in investment in growing
  industries and decrease in declining industries
• Defined as industry-specific elasticity of
  investment with respect to value added
• Growth growth in value added (1980 1990)

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Predation and Autocracy Measures

• Predation index (source ICRG) includes
• Corruption in government
• Rule of law
• Quality of bureaucracy
• Risk of repudiation of contracts by government
• Risk of expropriation of private investment
• Autocracy index (source POLITY) includes
• Competitiveness of political participation
• Regulation of participation
• Openness of executive recruitment
• Constraints on the chief executive

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Additional Control Variables

• Interaction of industry financial need ((capital
  expenditures cash flows from operations)/capital
  expenditures) with country financial development
  (sum of market capitalization and private credit
  to GDP)
• Interaction of intangible assets intensity with
  country expropriation risk (Claesens and Laeven,
  2003 when property rights are secure,
  intangible-intensive industries grow faster)

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Results Descriptives

• Highest aggregate financial transparency leather
  products
• Highest joint transparency fabricated metal
  products
• Manufacturing of industrial chemicals lowest on
  both
• Best investment efficiency petroleum and coal
  products, worst iron and steel
• Highest growth scientific equipment, lowest
  shipbuilding and repairs

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Results Investment Efficiency and Predation
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Results Investment Efficiency and Autocracy
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Results Transparency and Growth
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Robustness External Financing Channel

• Firms in greater need for external financing are
  more likely to need higher transparency
• Rajan and Zingales (1998) slower growth for
  industries in need of external financing
• Are we just replicating their result using a
  different measure?
• We explicitly decompose transparency into the
  part driven by external financing and part
  explained by other factors
• Our results go beyond those in Rajan and Zingales

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Robustness External Financing Channel
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Robustness Endogeneity

• Government predation policies could be endogenous
  to the level of economic development and, thus,
  capital allocation and growth
• We instrument autocracy and predation indices
  using English language dummy, distance from the
  equator, openness of the economy (Hall and Jones,
  1997)
• Results remain unchanged or become stronger

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Robustness Endogeneity
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Conclusion

• High level of transparency has been perceived as
  a positive phenomenon, as it alleviates
  informational asymmetry
• Motives for exceeding minimum diclosure have been
  widely acknowledged
• However, high transparency is harmful if property
  right are weak
• Industries that need high transparency will be
  affected disproportionally
• Result worse capital allocation and slower
  growth
• Benefits of transparency do not necessarily apply
  to markets with insecure property rights