Financial Globalization, Corporate Governance, and Eastern Europe

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

2. 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.

3. Neo-classical world upside down?

4. 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.

5. 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. Implications of twin agency problems

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

7. Date 1 Portfolio payoff 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

8. 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

9. 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

10. 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

11. The value of cash

12. 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.

13. The neo-classical world

14. The world with the twin agency problems

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

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

17. Governance indicator: Overall

18. Governance indicator: Rule of law

19. Governance indicator: Corruption

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

21. Ownership concentration in Eastern Europe

22. Ownership concentration through time

23. 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.

24. CSLA ratings

25. Firm valuations • Expect low firm valuations. • Data on Tobin’s q from Doidge, Karolyi, and Stulz. • Data from Worldscope.

26. Tobin’s Q in 2004

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

28. Financial Development in Eastern Europe

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

30. U.S. portfolio holdings in Eastern Europe

31. 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.

32. 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.