Investment and Institutions

1. Investment and Institutions Stijn Claessens, Kenichi Ueda, and Yishay Yafeh International Monetary Fund and University of Amsterdam, International Monetary Fund, and Hebrew University 16th Dubrovnik Economic Conference, June 24, 2010 The views expressed in this paper are those of the authors and should not be attributed to the International Monetary Fund, its Executive Board or its management.

2. Motivation • Capital is not always allocated efficiently (Hsieh and Klenow, 2009; Abiad, Oomes, and Ueda, 2008) • TFP is the most important factor for growth. • Does the institutional environment affect the cross-country differences in investment efficiency, and, if so, which institutions and how? • How should we judge the cross-country differences in investment efficiency?

3. Our Conjecture • Tobin’s Q is a measure of investment efficiency. • Tobin’s Q should be 1 in a perfect world. • If not, it should approach 1 over time. • This adjustment may be slower in countries with worse institutions.

4. Main Results • Good institutions can affect the investment efficiency through two channels: • Lower required return allows a larger adjustment in Q (from above) as the required capital gain (given current profits) is less. • Less financial frictions create less divergence of Tobin’s Q from its steady state to begin with, implying slower adjustment in Q.

5. Main Results • Thus, Implication of efficient investment on overall adjustment speed of Q is theoretically unclear. • We estimate the institutional effects through each of two channels separately using a canonical model of investment. • Regression results support beneficial effects of good corporate governance, operating through both channels, and high general institutional quality, operating through financial friction channel.

6. Literature: Finance-Efficiency Link • Efficiency of allocating capital across sectors has been estimated using a variety of measures • GDP growth or TFP growth (e.g., Beck, Loayza, and Levine, 2000; De Nicolo, Laeven, and Ueda, 2008) • Industry growth (e.g., Rajan and Zingales, 1998, and Wurgler, 2000). • Dispersion of firm-level productivity (e.g., Hsieh and Klenow, 2009, and Abiad, Oomes, and Ueda, 2008).

7. Literature: Tobin’s Q • Tobin's Q measures efficiency in the use of capital (Tobin, 1969) Speed of investment adjustment relates to Q (Mussa, 1977). • Because of adjustment costs, investment and Tobin’s Q relate in non-linear ways (Abel and Eberly, 1994) without financial frictions. • With financial frictions, the sign of cash-flow sensitivity of investment becomes difficult to predict (Gomes, 2000). • Moreover, market imperfections and varying discount factors affect movements in Q (Abel and Eberly, 2008). • (Measurement error issues are discussed later.)

8. Literature: Measures of Systems • Many measures have been developed/collected for institutional and financial development (e.g., Demirguc-Kunt and Levine, 2001, Morck et al, 2000, La Porta et al., 2008). • These allow comparisons of financial and governance systems around the world.

9. Model • Develop a canonical model of Tobin’s Q with both adjustment cost of investment and financial frictions (Abel and Blanchard (1986), Abel and Eberly (1994, 2008), Gomes (2000), and Hennessy et al. (2007)).

10. Timing Given K– and revealed current productivity ε at the beginning of the current period: • Investment I is determined • Adjustment costs ϕare wasted on investment • New capital K is formed and usable immediately • Using K, goods are produced with productivity ε • Fees λ paid for external financing (over-the-period)

11. Model

12. Timing • First-order condition • Envelope condition • Combined together and use

13. Adjustment Speed of Q • Adjustment in Q depends on required return and frictions • Lower required return allows a larger adjustment in Q (from above) as the required capital gain (given current profits) is less. • Less financial frictions creates less divergence of Tobin’s Q from its steady state to begin with, implying slower adjustment in Q.

14. Empirical Method: Minimize Forecast Errors • Assume adjustment costs/financial frictions are functions of real environment and firm characteristics X and institutional factors W: • We observe realized value of Q instead of expectation E[Q]. • One-period-ahead forecast errors are not serially correlated. Minimize mean squared errors: OLS is unbiased and consistent.

15. Estimation: Parameterization of Costs

16. Assumptions on Parameters and Variables • Each coefficient (a2, a3, b1, b2, and b3) of adjustment cost and financial friction functions are assumed to be linear functions of real environment and characteristics (X) and institutional factors (W). • Make similar assumption for the required return r, which constitute a coefficient c on lagged Q.  c(X, W)

17. Equation to be Estimated

18. Firm Level Data • Firm level data: Worldscope, 1990-2007, 48 countries. • Before tax income / After tax income • Capital investment / Capex + security investment • RZ external finance / Increase in debt + equity fin.

19. Macroeconomic and Firm Characteristics (X) • Firm Age: based on Founded Date. • Industry: SIC 2 digit. • Interest rate: Real short-term government rate • Inflation: CPI inflation • Macroeconomic Volatility • Standard deviation of real GDP growth 1995-2006 • Coefficient of variation of the exchange rate • Standard deviation of inflation

20. Institutions (W) • Corporate Governance (Shareholder Protection) • Anti-director index (La Porta, et al., 1998; Spamann, 2009) • Self-dealing index (Djankov, et al., 2008) • CGQ index (De Nicolo, Laeven and Ueda, 2008) • Creditor Rights • Strength of Legal Rights (for creditors/borrowers) (Doing Business) • Creditor Rights (Djankov, McLeish, and Shleifer, 2007) • Efficiency in Bankruptcy (World Economic Forum, 2004)

21. Institutions (W) • General Institutional Quality • Property rights (La Porta et al. 1998) • Rule of law (Kraay and Kaufman, 2000) • Trust in people (World Values Survey, 1990-93) • Competitiveness (of the product market) • Trade barriers (World Economic Forum, 2007) • Degree of new entry in business (World Development Indicators, 2008) • Number of listed firms in the population (WDI)

22. Institutions (W) • Financial Market Development • Stock market-capitalization-to-GDP ratio (International Financial Statistics) • Private credit (stocks + debt) to GDP ratio (International Financial Statistics) • Lack of foreign ownership restrictions (World Economic Forum)

23. Benchmark All Together

24. One-by-One: Almost the same results

25. Findings on Required Return • Only corporate governance significantly lowers the required return (in many specifications) • One std dev change in anti-director rights (1.3), mean Q goes down by 0.2 for average firm with Q=3. • Product market competition increases required return (though not so often) • Firm age very slightly increase required return. • (As a firm becomes older and bigger, its returns comove more with market portfolio, reducing insurance premium.) • Other factors do not have robust effects.

26. Findings on Internal Fin Frictions (2)-(4) • Slope and curvature of costs associated with the size of external finance is little affected by any institutional factors. • Better general institutional quality sometimes worsen the curvature but not robust.

27. Findings on Internal Fin Frictions (2)-(4) • Extra costs that small firms need to pay (small-firm premium) are less in country with better corporate governance and general institutional quality (column 3). • One std dev improvements in CG lowers the premium by about 3 cents per dollar asset. • One std dev improvements in institutional quality lowers premium by about 4 cents per dollar assets. • Other factors do not have robust effects on financial frictions.

28. Real Adj. Cost of Investment • Real adjustment cost of investment are not affected by X. • How about institutional factors W? • Entrenchment of managers under private information (Myers and Majluf (1984) and workers’ sabotage (Parente and Prescott, 2000) • We find: • Better corporate governance and general institutional quality reduce technological/managerial diseconomy of scale. • But somewhat offset by increased curvature. • Without coeff on investment, overall effect is unidentified. • Other institutional factors do not have significant effects. • All effects on financial frictions and required returns are unchanged.

29. Real Adj. Cost of Investment – CG lowers

30. Measurement Error Issues • Stock Price Movements may not always reflect fundamental values: • Abel and Blanchard (1986), Blanchard, Rhee, and Summers (1994), Phillippon (2009) – need long time series • Accounting Issues: • Difference between marginal and average Q  Hayashi’s (1982) assumptions make them the same; we also allow for industry and age specific effects. • Blanchard, Rhee, and Summers (1994): market valuation in debt and the replacement cost of capital—need long T.

31. Measurement Error Issues • Different Timing: • The productivity shock may not be revealed at the end of last period. If so, we observe E[Q –] instead of Q –. • The problem is similar to the case with noisy stock price. • These three measurement errors may be big or small. Need to test.

32. Testing Measurement Errors • With measurement errors, the OLS errors are serially correlated (even if measurement errors are not). • Cannot reject Ho (zero autocorrelation) in OLS errors.

33. IV Estimation • Measurement errors turns out small, if any, relative to one-period-ahead forecast errors. • Still, to check robustness, we run IV estimation. • Note that, if any, there is little autocorrelation in measurement errors. Large swings in stock prices is likely to dominate the other sources. • We use twice-lagged Q as an instruments for lagged Q (and fitted cross-terms as IV for cross-terms). TSLS results are similar to the OLS-FE estimation.

34. IV estimation – size and curvature effects

35. Conclusion • We have investigated how institutional environment affect investment efficiency. • Good corporate governance and general institutional quality, though less robust, are the main driving forces to lower financial frictions, in particular, the small-firm premium. • Also, better corporate governance lowers the required return in many specifications.

36. Conclusion • Why is corporate governance, not creditor rights, important? Our interpretation: • At the margin, the cost of equity finance determines the cost of borrowing. • Cost of external finance implicitly measures investors’ fear on mismanagement of injected cash.

37. Appendix • Suppose the firm-level shock following cdf F can be decomposed into the aggregate shock following cdf G, industry-specific shock following cdf H, and idiosyncratic shock. Three components are assumed to be orthogonal each other. • Firm managers can figure out overall shock ε when they make investment decision, but cannot know the size of each component.

38. Appendix