Financial Globalization, Corporate Governance, and Eastern Europe

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Financial Globalization, Corporate Governance,
and Eastern Europe

• René M. Stulz

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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.

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Neo-classical world upside down?
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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.

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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.

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Roadmap

• The twin agency problems.
• Implications for financial globalization.
• Eastern Europe.
• Conclusion.

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The Model
Date 0
Private benefits
State expropriation
Entrepreneur starts firm
Sells equity to public
Liquidating dividend
Entrepreneur does not start firm
Becomes portfolio investor
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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

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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

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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

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The value of cash
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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.

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The neo-classical world
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The world with the twin agency problems
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Macroeconomic implications

• Home bias.
• Savings-investment correlation.
• Consumption correlation across countries.
• Financial market development.
• Economic growth.

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Eastern Europe

• How good is governance?
• Use World Bank indicators and compare to similar
  income countries as well as to Western countries.

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Governance indicator Overall
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Governance indicator Rule of law
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Governance indicator Corruption
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Implication

• From the theory, we expect concentrated
  ownership.
• Source of data is Worldscope.
• Alternative approaches also show that ownership
  is concentrated in Eastern Europe.

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Ownership concentration in Eastern Europe
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Ownership concentration through time
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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.

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CSLA ratings
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Firm valuations

• Expect low firm valuations.
• Data on Tobins q from Doidge, Karolyi, and
  Stulz.
• Data from Worldscope.

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Tobins Q in 2004
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Financial development

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

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Financial Development in Eastern Europe
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Foreign investor participation

• Expect low foreign investor participation.
• Data from U.S. Treasury International Capital
  System (TIC) for U.S. investors.

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U.S. portfolio holdings in Eastern Europe
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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.

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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.