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Corporate governance in emerging markets: A survey☆

Stijn Claessens a, B. Burcin Yurtoglu b,⁎a Research Department, International Monetary Fund, University of Amsterdam, The Netherlands, CEPR and ECGI b WHU –Otto Beisheim School of Management, Germany

a r t i c l e i n f o a b s t r a c t

Available online xxxx This paper reviews recent research on corporate governance, with aspecial focus on emerging markets. It nds that better corporategovernance benet rms through greater access to nancing, lowercost of capital, better performance, and more favorable treatment of all stakeholders. Numerous studies show these channels to operate atthe level of rms, sectors and countries—with causality increasinglyoften clearly identied. Evidence also shows that voluntary and

market corporate governance mechanisms have less effect when acountry's governance system is weak. Importantly, how corporategovernance regimes change over time and how this impacts rms arereceiving more attention recently. Less evidence is available on thedirect links between corporate governance and social and environ-mental performance. The paper concludes by identifying issuesrequiring further study, including the special corporate governanceissues of banks, and family-owned and state-owned rms, and thenature and determinants of public and private enforcement.

© 2012 Elsevier B.V. All rights reserved.

JEL classi cation:

G3

Keywords:

Corporate governanceEmerging markets

Shareholder rightsPerformanceValuationCreditor rightsStakeholders

Contents

1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 02. What is corporate governance?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 03. How do countries differ in aspects relevant to corporate governance?. . . . . . . . . . . . . . . . . 0

3.1. The diversity in economic and nancial environments. . . . . . . . . . . . . . . . . . . . . 03.2. The diversity in institutional environments . . . . . . . . . . . . . . . . . . . . . . . . . . 03.3. The diversity in ownership structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . 03.4. The diversity in group af liation and institutional investors . . . . . . . . . . . . . . . . . . 0

Emerging Markets Review xxx (2012) xxx–xxx

☆ The views expressed here are those of the authors and do not necessarily represent those of the IMF or IMF policy.⁎ Corresponding author.E-mail addresses: [email protected] (S. Claessens), [email protected] (B.B. Yurtoglu).

EMEMAR-00292; No of Pages 33

1566-0141/$ – see front matter © 2012 Elsevier B.V. All rights reserved.doi:10.1016/j.ememar.2012.03.002

Contents lists available at SciVerse ScienceDirect

Emerging Markets Review

j o u r n a l h o m e p a g e : w w w . e l s e v i e r . c o m / l o c a t e / e m r

Please cite this article as: Claessens, S., Yurtoglu, B.B., Corporate governance in emerging markets: Asurvey , Emerging Markets Review (2012), doi:10.1016/j.ememar.2012.03.002

http://dx.doi.org/10.1016/j.ememar.2012.03.002http://dx.doi.org/10.1016/j.ememar.2012.03.002http://dx.doi.org/10.1016/j.ememar.2012.03.002mailto:[email protected]:[email protected]://dx.doi.org/10.1016/j.ememar.2012.03.002http://www.sciencedirect.com/science/journal/15660141http://dx.doi.org/10.1016/j.ememar.2012.03.002http://dx.doi.org/10.1016/j.ememar.2012.03.002http://www.sciencedirect.com/science/journal/15660141http://dx.doi.org/10.1016/j.ememar.2012.03.002mailto:[email protected]:[email protected]://dx.doi.org/10.1016/j.ememar.2012.03.002


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4. How and through what channels does corporate governance matter? . . . . . . . . . . . . . . . . . 04.1. Increased access to nancing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 04.2. Higher rm valuation and better operational performance . . . . . . . . . . . . . . . . . . . 04.3. Less volatile stock prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 04.4. Better functioning nancial markets and greater cross-border investments . . . . . . . . . . . . 0

4.5. Better relations with other stakeholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . 04.5.1. Stakeholder management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 04.5.2. Social issue participation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

5. Corporate governance reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 05.1. Recent country level reforms and their impact . . . . . . . . . . . . . . . . . . . . . . . . . 0

5.1.1. Legal reforms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 05.1.2. Corporate governance codes and convergence . . . . . . . . . . . . . . . . . . . . . 05.1.3. The role of rm-level voluntary corporate governance actions . . . . . . . . . . . . . 05.1.4. Voluntary adoption of corporate governance practices . . . . . . . . . . . . . . . . . 05.1.5. Boards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 05.1.6. Cross-listings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 05.1.7. Other mechanisms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

5.1.8. The role of political economy factors . . . . . . . . . . . . . . . . . . . . . . . . . 06. Conclusions and areas for future research. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

1. Introduction

Corporate governance, a phrase that a decade or two ago meant little to all but a handful of scholarsand shareholders, has become a mainstream concern—a staple of discussion in corporate boardrooms,

academic meetings, and policy circles around the globe. Several events are responsible for the heightenedinterest in corporate governance. During the wave of nancial crises in 1998 in Russia, Asia, and Brazil, thebehavior of the corporate sector affected entire economies, and deciencies in corporate governanceendangered global nancial stability. Just a few years later condence in the corporate sector was sappedby corporate governance scandals in the United States and Europe that triggered some of the largestinsolvencies in history. And the most recent nancial crisis has seen its share of corporate governancefailures in nancial institutions and corporations, leading to systemic consequences. In the aftermath of these events, not only has the phrase corporate governance become more of a household term, but alsoresearchers, the corporate world, and policymakers everywhere recognize the potential macroeconomic,distributional and long-term consequences of weak corporate governance systems.

Thecrises, however, are just manifestationsof a number of structural reasons why corporate governance has

become more important for economic development and well-being. The private, market-based investmentprocess is much more important for most economies than it used to be, and that process needs to beunderpinned by goodcorporategovernance. Withrmsincreasinginsizeandtheroleof nancial intermediariesand institutional investors growing, the mobilization of capital is increasingly one step removed from theprincipal–owner. At the same time, the allocation of capital has become more complex as investment choiceshave widened with the opening up and liberalization of nancial and real markets, and as structural reforms,including price deregulation and increased competition, have increased companies' exposure to market forcesrisks. At the same time, the recent nancial crisis has reinforced how failures in corporate governance can ruincorporationsand adverselyaffect whole economies. These developmentshave made themonitoring oftheuse of capital more complex in many ways, enhancing the need for good corporate governance.

This paper traces the many dimensions through which corporate governance works in rms and

countries. To do so, it reviews the extensive literature on the subject—

and identi

es areas where more studyis needed. A large body of research has over the last two decades documented the importance of legalfoundations, including the quality of the corporate governance framework, for economic development.Research has shown links between law and economics, highlighting the roles of legal foundations and well-dened property rights for properly functioning market economies. This literature has also addressed the

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importance and impact of corporate governance.1 Research, however, has expanded less into emergingmarkets and even less so to developing countries, and much work still refers to situations in developedcountries, in particular the United States. Furthermore, research often focuses on the relationship betweencorporate governance and economic development and not on other measures of well-being. The purpose of this paper is to ll these gaps.

The paper is structured as follows. It starts with a denition of corporate governance, as that determinesthe scope of the issues, and reviews how corporate governance can and has been dened. The paper nextexplores in which ways corporate governance may matter, and especially how it affects corporations inemerging markets. It does so by providing extensive background on countries' economic, nancial andinstitutional environments, including ownership patterns, around the world that determine and affect thescope and nature of corporate governance problems. This section highlights that corporate governance issuesin emerging markets vary from those in advanced countries due to still-limited development of privatenancial markets and poor access to nancing, concentrated ownership structures, and low institutionalownership. After showing some of the differences among emerging markets, such as the variation ingovernance structures between East Asia and recent EU-member Central and Eastern Europe countries, thissection also documents the differences in levels of market pressures, political/government inuence, capital

cost controls, internalization of stakeholder interests, governance spillovers through inward FDI, outward FDIand tapping of international capital markets among emerging markets and between emerging markets andadvanced countries. These issues help set the stage of the remaining discussion in the paper.

After analyzing what the theoretical literature has to say about the various channels through whichcorporate governance affects economic development and well-being, the paper reviews the empirical factsabout these relations. It explores recent research documenting how (changes in) legal aspects can affectrmvaluation, inuence the degree of corporate governance problems, and more broadly affectrm performanceand nancial structure. It then reviews the evidence on how a number of (voluntary) corporate governancemechanisms – ownership structures, boards, cross-listing, use of independent auditors – affect rmperformance and behavior. It also reviews research on the factors that play a role in countries' willingness toundertake corporate governance reforms. The paper concludes by identifying some main policy and research

issues that require further study.

2. What is corporate governance?

Denitions of corporate governance vary widely. They tend to fall into two categories. The rst set of denitions concerns itself with a set of behavioral patterns: that is, the actual behavior of corporations, interms of such measures as performance, ef ciency, growth,nancial structure, and treatmentof shareholdersand other stakeholders. The second set concerns itself with the normative framework: that is, the rules underwhich rms are operating—with the rules coming from such sources as the legal system, the judicial system,nancial markets, and factor (labor) markets.

For studies of single countries orrmswithin a country, the rsttypeofdenition is the most logical choice.

It considerssuch matters ashow boards of directors operate,the role of executive compensation in determiningrm performance, the relationship between labor policies and rm performance, and the role of multipleshareholders. For comparative studies, the second type of denition is the more logical one. It investigates howdifferences in the normative framework affect the behavioral patterns of rms, investors, and others.

In a comparative review, the question arises how broadly to dene the framework for corporategovernance. Under a narrow denition, the focus would be only on the rules in capital markets governingequity investments in publicly listed rms. This would include listing requirements, insider dealingarrangements, disclosure and accounting rules, and protections of minority shareholder rights.

Under a denition more specic to the provision of nance, the focus would be on how outsideinvestors protect themselves against expropriation by the insiders. This would include minority rightprotections and the strength of creditor rights, as reected in collateral and bankruptcy laws, and their

enforcement. It could also include such issues as requirements on the composition and the rights of theexecutive directors and the ability to pursue class-action suits. This denition is close to the one advanced

1 The rst broad survey of corporate governance was Shleifer and Vishny (1997). Several surveys have since followed, includingBecht et al. (2003), Claessens and Fan (2002), Denis and McConnell (2003), and Holmstrom and Kaplan (2001).

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by Shleifer and Vishny in their seminal 1997 review: “Corporate governance deals with the ways in whichsuppliers of nance to corporations assure themselves of getting a return on their investment ” (1997, p. 737).This denition can be expanded to dene corporate governance as being concerned with the resolution of collective action problems among dispersed investors and the reconciliation of con icts of interest between

various corporate claimholders.A somewhat broader denition would be to dene corporate governance as a set of mechanisms through

which rms operate when ownership is separated from management. This is close to the denition used bySir Adrian Cadbury, head of the Committee on the Financial Aspects of Corporate Governance in the UnitedKingdom: “Corporate governance is the system by which companies are directed and controlled” (CadburyCommittee, 1992).

An even broader denition is to dene a governance system as “the complex set of constraints that shapethe ex post bargaining over the quasi rents generated by the rm” (Zingales, 1998, p. 499). This denitionfocuses on the division of claims and can be somewhat expanded to dene corporate governance as thecomplex set of constraints that determine the quasi-rents (pro ts) generated by the rm in the course of

relationships with stakeholders and shape the ex post bargaining over them. This denition refers to both thedetermination of value-added by rms and the allocation of it among stakeholders that have relationships

with the rm. It can be read to refer to a set of rules, as well as to institutions.Corresponding to this broad denition, the objective of a good corporate governance framework would

be to maximize the contribution of rms to the overall economy—that is, including all stakeholders. Underthis denition, corporate governance would include the relationship between shareholders, creditors, andcorporations; between nancial markets, institutions, and corporations; and between employees andcorporations. Corporate governance would also encompass the issue of corporate social responsibility,including such aspects as the dealings of the rm with respect to culture and the environment.

When analyzing corporate governance in a cross-country perspective, the question arises whether theframework extends to rules or institutions. Here, two views have been advanced. One is the view that theframework is determined by rules, and related to that, to markets and outsiders. This has been considereda view prevailing in or applying to Anglo-Saxon countries. In much of the rest of the world, institutions –

specically banks and insiders – are thought to determine the actual corporate governance framework.In reality, both institutions and rules matter, and the distinction, while often used, can be misleading.

Moreover, both institutions and rules evolve over time. Institutions do not arise in a vacuum and areaffected by the rules in the country or the world. Similarly, laws and rules are affected by the country'sinstitutional setup. In the end, both institutions and rules are endogenous to other factors and conditionsin the country. Among these, ownership structures and the role of the state matter for the evolution of institutions and rules through the political economy process. Shleifer and Vishny (1997, p. 738) take adynamic perspective by stating: “Corporate governance mechanisms are economic and legal institutions that can be altered through political process.” This dynamic aspect is very relevant in a cross-country review, buthas received attention from researchers only lately.

When considering both institutions and rules, it is easy to become bewildered by the scope of institutions

and rules that can be thought to matter. An easier way to ask the question of what corporate governancemeans is to take the functional approach. This approach recognizes that nancial services come in manyforms, but that if the services are unbundled, most, if not all, key elements are similar (Bodie and Merton,1995). This line of analysis of the functions – rather than the specic products provided by nancialinstitutions, and markets– has distinguished sixtypes of functions: pooling resources andsubdividing shares;transferring resources across time and space; managing risk; generating and providing information; dealingwith incentive problems; and resolving competing claims on the wealth generated by the corporation. Onecan operationalize the denition of corporate governance as the range of institutions and policies that areinvolved in these functions as they relate to corporations. Both markets and institutions will, for example, affectthe way the corporate governance function of generating and providing high-quality and transparentinformation is performed.

3. How do countries differ in aspects relevant to corporate governance?

The nature of the corporate governance challenges is importantly determined by the countries' overalldevelopment and institutional environment, and specically by prevailing ownership structures. This section





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Table 1A

Macroeconomic and nancial indicators.

Country Per capitaGDP

GDPgrowth

Trade Foreign directinvestment

Privatecredit

Marketcapitalization

Stockstraded

2005 USD Annual % % of GDP % of GDP % of GDP % of GDP % of MC

Australia 32,248 3.2 40.3 2.8 115.8 114.9 80.9Austria 33,475 1.7 100.7 6.1 128.1 28.9 39.7Belgium 31,866 1.5 154.0 21.7 112.4 68.1 42.6Canada 34,369 2.1 72.8 3.7 184.1 112.4 76.0Denmark 32,808 0.9 92.9 3.9 178.7 62.7 83.0Finland 30,274 2.1 78.2 3.1 74.9 117.8 116.0France 29,519 1.4 53.2 3.0 112.1 83.7 101.1Germany 31,727 0.8 75.4 2.4 136.0 47.8 139.4Greece 24,179 3.4 56.1 0.9 91.8 57.7 48.3Iceland 33,277 3.1 79.9 9.4 184.1 102.1 69.8Ireland 36,936 3.8 161.5 6.7 153.7 53.9 49.0

Italy 28,055 0.5 52.8 1.3 112.0 43.2 123.6 Japan 29,841 0.7 26.1 0.2 304.6 77.5 107.2Luxembourg 67,207 3.4 289.2 347.0 . 163.3 1.0Netherlands 35,322 1.6 131.7 6.8 175.1 99.5 147.7New Zealand 24,430 2.4 60.4 3.0 128.8 37.2 51.0Norway 46,475 2.0 72.8 1.7 75.9 53.7 115.1Portugal 21,425 0.9 67.3 3.0 152.2 41.1 68.5Spain 26,956 2.6 57.2 3.7 160.7 86.9 174.4Sweden 31,927 2.0 88.8 5.0 112.4 104.8 124.3Switzerland 35,946 1.7 90.8 4.8 176.9 245.7 100.5United Kingdom 32,068 1.7 56.7 4.6 166.7 132.3 139.2United States 41,584 1.8 26.0 1.5 219.2 127.1 196.1Developed (avg) 33,561.5 2.0 86.3 19.4 148.0 89.7 95.4

Argentina 10,922 3.6 38.3 2.3 38.0 42.8 10.4

Bolivia 3648 3.7 61.4 3.7 57.5 18.9 0.9Brazil 8559 3.3 25.7 2.7 81.3 51.4 46.0Chile 11,900 3.7 71.9 6.5 88.6 104.2 14.3China 4164 10.3 57.6 3.1 134.0 65.9 121.9Colombia 7321 4.0 35.8 3.4 33.0 27.7 9.8Ecuador 6537 4.5 65.2 1.6 20.5 7.7 6.4Egypt, Arab Rep. 4423 4.9 54.2 3.8 92.3 54.8 35.6El Salvador 5680 2.1 69.9 2.7 45.6 19.2 4.5Ghana 1198 5.5 89.1 3.2 30.0 14.3 3.0Hong Kong, China 34,753 4.2 353.5 20.7 140.4 483.3 63.0India 2284 7.2 37.9 1.6 59.9 61.9 138.9Indonesia 3204 5.1 59.3 0.5 46.8 26.6 51.5Israel 23,645 3.6 77.8 4.1 79.6 79.7 58.5 Jamaica 6922 1.1 98.6 6.5 56.1 80.3 2.8 Jordan 4297 6.3 125.6 10.5 95.3 147.7 41.6Kenya 1342 3.6 60.1 0.6 39.6 28.8 7.7Korea, Rep. 22,439 4.4 79.4 0.7 95.0 66.3 248.0Malaysia 11,567 4.8 200.5 2.9 130.3 135.5 33.1Mexico 12,516 1.9 57.0 2.9 35.5 26.2 28.4Morocco 3493 4.8 69.0 2.2 80.3 50.9 21.0Nigeria 1697 6.1 73.3 3.3 17.7 19.6 14.5Pakistan 2136 4.6 32.2 1.8 44.0 24.1 289.4Panama 9464 5.8 140.5 7.0 89.9 27.6 2.3Peru 6436 5.1 41.6 3.3 19.9 42.4 7.8Philippines 2897 4.6 93.9 1.5 54.8 45.8 18.7Singapore 42,358 5.6 406.5 14.2 76.9 182.2 66.4South Africa 8533 3.6 59.0 1.9 175.2 202.4 47.4

Sri Lanka 3568 5.0 72.7 1.3 43.4 16.1 18.1Taiwan . . . . . . .Thailand 6563 4.1 134.0 3.6 127.7 55.7 88.8Tunisia 6414 4.7 101.9 4.3 72.4 13.3 14.7

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therefore provides for advanced countries, emerging markets and transition economies salient statistics on

both countries' economic andnancial environment as well as key aspects of their institutional environments,such as ease of contracting and the degree of legal and judicial ef ciency, with many measures and theirrelations with good corporate governance discussed in greater detail in the next sections. These comparisonshighlight that emerging markets differ in some key aspects from advanced countries, but also show muchvariation in some of these aspects across emerging markets. Since corporate governance issues and the role of corporate governance for economic development are best understood from the perspective of ownershipstructures and the related structures of business groups, the section next provides a review of the wide varietyin ownership concentration and business group structures across countries. The comparisons naturally lead tosubsequent discussions of the key corporate governance issues in emerging markets.

3.1. The diversity in economic and nancial environments

Economic and nancial conditions obviously differ greatly among countries. Table 1A reports, for asample of advanced countries, emerging markets and transition economies, key aspects importantlyinuencing corporate governance. First, it reports economic development and prospects. In terms of GDP

Table 1A (continued)

Country Per capitaGDP

GDPgrowth

Trade Foreign directinvestment

Privatecredit

Marketcapitalization

Stockstraded

2005 USD Annual % % of GDP

% of GDP % of GDP % of GDP % of MC

Turkey 10,472 3.8 48.7 1.7 47.9 27.4 156.6Uganda 914 7.2 42.0 4.1 9.4 0.9 2.1Uruguay 9915 2.3 51.9 3.8 48.3 0.6 3.9Venezuela, RB 9998 3.9 50.9 1.3 15.7 4.6 6.3Zimbabwe . -5.9 82.8 0.7 78.3 148.1 13.2Emerging markets (avg) 8919.4 4.2 89.4 3.9 66.7 66.8 47.2

Bulgaria 9563 4.7 115.4 13.8 39.4 16.5 19.2Croatia 14,940 3.3 89.6 5.8 60.9 36.4 6.2Czech Republic 19,981 3.4 138.0 6.0 49.6 26.0 63.8Hungary 16,178 2.7 142.7 14.5 63.6 24.7 76.4Kazakhstan 8306 8.6 93.3 9.2 28.0 22.0 13.5Latvia 12,267 4.8 98.3 4.2 62.0 9.7 13.2Lithuania 13,506 4.8 115.0 3.6 38.8 19.3 11.8Poland 13,899 3.9 72.9 3.9 43.2 26.4 37.6Romania 9196 4.5 74.6 5.2 25.3 14.6 14.9Russian Federation 11,574 5.5 56.9 2.4 25.9 56.3 54.0Slovak Republic 16,207 4.5 162.8 4.8 50.8 6.3 24.8Ukraine 5290 4.7 104.0 4.3 45.1 21.9 6.0 Transition (avg) 12,575.6 4.6 105.3 6.5 44.4 23.3 28.5

Denitions of the indicators and their sources

Indicator Denition Period Source

Per capita GDP GDP per capita, PPP in constant 2005 international USD. 2000–2010 WDIGDP growth Annual percentage growth rate of GDP at market prices based

on constant local currency.2000–2010 WDI

Trade Sum of exports and imports of goods and services measured asa share of gross domestic product. 2000–

2010 WDI

Foreign direct investment Foreign direct investment, net inows as a share of grossdomestic product.

2000–2010 WDI

Private credit Domestic credit to private sector as a share of gross domesticproduct.

2000–2010 WDI

Market capitalization (MC) Market capitalization of listed companies as a share of grossdomestic product.

2000–2010 WDI

Stocks traded Total value of shares traded divided by the average marketcapitalization for the period.

2000–2010 WDI





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Table 1B

Governance indicators.

Country Legal origin Legalrights strength

Creditorrights

Legal protectionof minorityshareholders

Ef ciencyof debtenforcement

Anticorruption

Disclosurerequirements

Corporategovernanceopacity

Index Index Index Index Index Index Index

Australia British 9.0 3 79 87.8 196 75 21Austria German 7.0 3 21 78.0 198 25 13Belgium French 7.0 2 54 90.8 137 42 13Canada British 6.0 1 65 93.2 205 92 20Denmark Scandinavian 8.7 3 47 76.7 244 58 21Finland Scandinavian 7.0 1 46 92.4 242 50 13France French 5.8 0 38 54.1 137 75 10Germany German 7.7 3 28 57.0 188 42 12Greece French 3.0 1 23 53.8 38 33 7Iceland Scandinavian 7.0 . 24 . 218 . 0Ireland British 8.0 1 79 89.9 160 67 16

Italy French 3.0 2 39 45.3 33 67 10 Japan German 6.8 2 48 95.5 119 75 10Luxembourg French 7.0 . 25 . 195 . 6Netherlands French 6.0 3 21 94.9 215 50 18New Zealand British 10.0 4 95 90.7 235 67 16Norway Scandinavian 7.0 2 44 91.8 210 58 17Portugal French 3.0 1 49 82.3 113 42 2Spain French 6.0 2 37 82.0 119 50 6Sweden Scandinavian 4.8 1 34 86.0 225 58 21Switzerland German 8.0 1 27 60.4 212 67 14United

KingdomBritish 9.0 4 93 92.3 190 83 14

UnitedStates

British 8.0 1 65 85.8 152 100 21

Developed(avg)

6.7 2.0 46.9 80.0 173.1 60.7 13.1

Argentina French 4.0 1 44 35.8 −40 50 8Bolivia French 1.0 2 8 . −59 . .Brazil French 3.0 1 29 13.4 −3 25 10Chile French 4.0 2 63 40.9 142 58 13China German 4.8 2 78 43.6 −47 . 5Colombia French 5.0 0 58 64.8 −26 42 5Ecuador French 3.0 0 8 19.4 −86 0 .Egypt, Arab

Rep.French 3.0 2 49 28.6 −46 50 4

El Salvador French 5.0 3 57 37.8 −46 . .Ghana British 6.5 1 73 . −12 . .Hong Kong,

ChinaBritish 10.0 4 96 88.3 179 92 .

India British 7.2 2 55 . −40 92 7Indonesia French 3.0 2 68 25.1 −82 50 9Israel British 9.0 3 71 66.2 99 67 16 Jamaica British 8.0 2 35 69.0 −41 . . Jordan French 4.0 1 16 44.5 17 67 7Kenya British 10.0 4 22 . −95 50 10Korea, Rep. German 7.0 3 46 88.1 41 75 .Malaysia British 10.0 3 95 48.4 28 92 9Mexico French 5.0 0 18 72.6 −28 58 6Morocco French 3.0 1 57 41.9 −14 . 6Nigeria British 8.0 4 52 . −110 67 18Pakistan British 6.0 1 41 . −94 58 14

Panama French 6.0 4 15 43.0 −31 . .Peru French 5.7 0 41 41.8 −27 33 8Philippines French 3.0 1 24 17.5 −56 83 9

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per capita (column 1), emerging markets and transition economies rank still much below advancedcountries. Some emerging markets, though, such as Hong Kong and Singapore, exceed in terms of per

capita income in many advanced countries, while others, such as Korea and Hungary, are ahead or not farbehind some advanced countries. As is well known, GDP growth has been much higher recently inemerging markets and transition economies than in advanced countries (column 2), almost double.

Important impetus for corporate governance improvements has been the internationalization andglobalization in trade and nance. The next column (3) shows that in terms of trade integration emerging

Table 1B (continued)

Country Legal origin Legalrights strength

Creditorrights

Legal protectionof minorityshareholders

Ef ciencyof debtenforcement

Anticorruption

Disclosurerequirements

Corporategovernanceopacity

Index Index Index Index Index Index Index

Singapore British 10.0 3 100 96.1 226 100 9South Africa British 9.0 3 81 39.8 40 83 16Sri Lanka British 3.3 2 41 45.7 −24 75 7Taiwan German 2 56 93.8 67 75 0Thailand British 4.0 2 85 54.9 −24 92 8Tunisia French 3.0 0 17 56.6 1 . .Turkey French 4.0 2 43 6.6 −18 50 11Uganda British 7.0 2 41 . −82 . .Uruguay French 5.0 3 17 28.6 96 0 .Venezuela,

RBFrench 2.0 3 9 13.1 −98 17 23

Zimbabwe British 6.0 4 44 . −116 50 .Emerging

markets

(avg)

5.5 2.0 47.3 47.1 −11.0 58.9 9.5

Bulgaria German 8.0 2 66 46.0 −20 . 12Croatia German 5.3 3 25 45.0 −7 . 3Czech

RepublicGerman 6.7 3 34 40.7 37 . 18

Hungary German 7.0 1 20 46.7 55 . 2Kazakhstan French 4.0 2 48 31.4 −100 . 11Latvia German 9.0 3 35 49.3 4 . .Lithuania French 5.0 2 38 58.7 14 . 10Poland German 8.2 1 30 67.7 36 . 11Romania French 7.5 1 41 11.0 −28 . 10Russian

Federation

French 3.0 2 48 39.0 −92 . 11

SlovakRepublic

German 9.0 2 29 58.9 27 . 0

Ukraine French 8.3 2 11 17.5 −91 . 0 Transition

(avg)

6.8 2.0 35.4 42.7 −13.8 . 8.0

Denitions of the indicators and their sources

Indicator Denition Period Source

Legal origin Legal origin. 1999 La Porta et al. (1999)Legal rights strength Strength of legal rights index

(0 = weak, 10 = strong)2000–2010 WDI (World Development Indicators,

World Bank)Creditor rights Creditor rights aggregate score

(0 = weak, 4 = strong).

2007 Djankov et al. (2007)

Legal protection of minority shareholders

Anti-self-dealing index in bp(0 = weak, 100 = strong).

2006 La Porta et al. (2006)

Ef ciency of debtenforcement

Ef ciency of debt enforcement(0 = weak, 100 = strong).

2006–2008 Djankov et al. (2008a)

Anti corruption Average corruption score(higher numbers mean “less corrupt”).

1996–2000 WGI (Worldwide GovernanceIndicators, World Bank Institute)

Disclosure requirements Disclosure requirements index in bp(0 = weak, 100 = strong).

2006 La Porta et al. (2006)





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markets and transition economies do not differ anymore much from advanced countries, although thereare large differences among emerging markets (e.g., East Asian countries are typically much more open).Foreign direct investment (FDI) as a percent of GDP (column 4) still differs much across countries, withemerging markets and transition economies relying much less on FDI, than advanced countries do. Thereare differences though among emerging markets, with some East Asian countries much more reliant onFDI.

Another important force has been nancial market pressures. Here, however, there remain relativelylarge differences among countries, as shown by the ratio of credit to GDP (column 5). Advanced countrieshave much deeper nancial systems, with ratios more than double those of emerging markets and almostthree times those of transition economies. But the variation among emerging markets is very large as well.Many countries in East Asia, for example, have ratios close to or more than 100%, whereas many LatinAmerican countries have ratios only half those. Also, some transition economies like Poland and Romaniascore relatively low in this respect, a reection of episodes of high ination.

Differences also exist in stock market development. Market capitalization as a share of GDP (column 6)is some 90% in advanced countries, versus 67% in emerging markets and only 23% in transition economies.Again, the differences among emerging markets are large. Besides many transition economies, Latin

American countries tend to have lowstock market development. In terms of thefrequency at which stocksarebeing traded, measured by the turnover ratio (column 7), emerging markets are more similar to advancedcountries, but transition economies show much lower turnover ratios than advanced countries do.

3.2. The diversity in institutional environments

Table 1B presents some salient institutional dimensions that matter for corporate governance andnancial markets development in general. Crucial are properly functioning legal and judicial systems. Thisinvolves a number of dimensions: the general legal denition and protection of property rights, and that of creditor and shareholder rights specically; the enforcement of legal rights by the judicial system; the lackof corruption in general; and the overall disclosure and transparency regime, especially that related to

corporate governance. Many of these aspects are of a qualitative nature and consequently not easilycaptured and codied. The comparisons nevertheless show some clear differences between countries.

The starting point for describing the legal system is often its origin (column 1): Common Law (British)or Civil Law, with the latter French or German in origin (a smaller category is Scandinavian), withCommon Law is generally considered to be better in terms of the overall strength of (formal) propertyrights protection. On this score, reecting past colonization, emerging markets do not differ much fromadvanced countries, but transition economies do in that they all have Civil Law origin. The strength of countries' formal legal rights, captured using an index based on various legal features (column 2), showslittle differences between advanced countries and transition economies, but emerging markets tend tohave less strongly dened rights. Formal rights are particularly weak in some African, Latin America andMiddle Eastern countries and tend to be better in common law origin emerging markets.

The rights of creditors and shareholders (column 3 and 4) are on average equally strongly dened inadvanced countries as in emerging markets and transition economies, except for shareholder rights whichare less strongly dened in transition economies. Still, these averages hide large variations, reect in partlegal origins. In many emerging market countries, formal rights of creditors are very weak (in Colombia,Egypt, and Mexico, for example, the score is a zero). Also shareholder rights are often very weak, especiallyin Latin America (scores in Bolivia, Ecuador, and Venezuela are less than 10 on a scale of 100).

What matters too is the degree of enforcement of formal rights. This aspect, while obviously hard tocodify, is captured in the ef ciency of enforcement (column 5) and the lack of corruption (column 6)indexes. These show much larger differences than the formal rights do. On average, enforcement is twice ashigh in advanced countries than in emerging markets andtransition economies. Also, corruptionis much less,but with again large variation. Some emerging markets like Chile, Hong Kong and Singapore score above

many advanced countries, while others dramatically fail to curb corruption (e.g., Kenya and Nigeria).The next index shows the degrees to which corporations listed on local stock exchanges have to discloserelevant nancial and other information (column 7). Differences between advanced countries and emergingmarkets are not large on average (data do not cover transition economies), but there is much more variationamong emerging markets. Malaysia, Thailand and South Africa have disclosure requirements that equal or





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exceedthose of most advanced countries, while those of others,such as Brazil, Ecuador, Uruguay andVenezuela,are very weak. An index of de-facto quality of corporate governance, based on actual corporations' behavior –how accounting statements are being provided, earnings are being smoothed, and stock prices behave andreect information about the rm – is shown next (column 8). It shows emerging markets and transitioneconomiesto score below advanced countriesas a group,with again large differences among emerging markets.

3.3. The diversity in ownership structures

The nature of the corporate governance problems importantly varies by ownership structures. For anindividual rm, ownership structure denes the nature of principal–agent issues. Here the differencebetween direct ownership – also called cash-ow rights – and control rights – who de facto runs thecorporation, also called voting rights – is very important. In many corporations, the controllingshareholder may have little direct equity stake, but through various constructions she may still exercisede facto full control. Another factor is group-af liation, especially important in emerging markets, wherebusiness groups can dominate economic activity. Of course, ownership and group-af liation structures

vary over time and can be endogenous to country circumstances, including economic and nancialconditions, and legal and other foundations (Shleifer and Vishny, 1997). As such, ownership and group-af liation structures both are affected by and affect legal and regulatory infrastructures.

Much of the early literature focused on conicts between managers and owners. But around the world,except for the United States and to some degree the United Kingdom, insider-controlled or closely-heldrmsare the norm (La Porta et al., 1998). Firms can be family-owned or nancial institutions-controlled. Familieslike the Peugeots in France, Quandts in Germany, and Agnellis in Italy hold large blocks of shares in andeffectively control the largest rms(Barca and Becht, 2001; Faccio and Lang, 2002). Even in the United States,family-owned rms are not uncommon (Holderness, 2009). In Japan and to some extent Germany, nancialinstitutions control large many corporations (Claessens et al., 2000; Faccio and Lang, 2002; La Porta et al.,1998). This control is frequently reinforced through pyramids and webs of shareholdings that allow families

or nancial institutions to use ownership of one rm to control many more with little direct investment.Most studies document a large shareholder with a controlling direct interest in listed companies in

emerging markets (Table A22 summarizes). In the East Asian countries Hong Kong, Indonesia, andMalaysia, the largest direct shareholdings, often families and also involved with management, owngenerally about 50%. Direct equity ownership is typically slightly more than 50% in India and Singapore,and less so in S. Korea (~20%), Taiwan (~30%), and Thailand (~40%). Financial institutions also havesizeable ownership stakes in Bangladesh, Malaysia, India and Thailand. Some corporations in India,Indonesia, Malaysia and Korea are foreign owned. Also some state ownership is reported in India,Malaysia, and Thailand, albeit by studies from the 1990s. A large divergence between cash ow and votingrights of controlling owners is reported for many East Asian corporations, with this divergence mostlymaintained by pyramid structures.

In Latin America, the typical largest shareholder owns more than 50% and even more than 60% inArgentina and Brazil. Similar to East Asia, most of the largest shareholders are wealthy families. In Chile,Colombia, Mexico and Peru, nancial and non-nancial companies are also direct owners. In contrast toEast Asia, non-voting stock and dual-class shares are more prevalent and divergence of cash ow rightsfrom voting rights is consequently more common in Latin America. Studies from Israel, Kenya, Turkey,Tunisia and Zimbabwe also point towards concentrated ownership and a large divergence of cash owrights from control rights. As such, this pattern seems to be the norm around the world.

Limited research mostly reports that ownership structures are fairly stable over time, except fortransition countries. Foley and Greenwood (2010) study the evolution of ownership in 34 countries.Almost everywhere, ownership tends to be concentrated following their initial public offering (IPO). Incountries with strong protections for minority investors and liquid stock markets, though, the typical rm

becomes widely held within 5 to 7 years. In the United States, for example, median block ownership dropsfrom 50% to 21% within 5 years. Nearly everywhere else, however,rms remain closely held even 10 yearsafter going public. In Brazil block holders still own half of the median rm 5 years after IPO. Carney and

2 Tables A2–A8 can be downloaded from http://www.whu.edu/uploads/media/_Appendix__Tables_2-8__01.pdf .



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Child (in press) analyze ownership changes in East Asia from 1996 to 2008 and report that family controlremains the most common form of ownership (less so among Northeast Asian rms and more so amongSoutheast Asian rms).

Ownership structures affect the nature of the agency problems between managers and outsideshareholders, and among shareholders. When ownership is diffuse, as is typical in the U.S. and the U.K.,agency problems stem from the conicts of interests between outside shareholders and managers whoown little equity in the rm ( Jensen and Meckling, 1976). In such countries, controlling managementactions is often key. When ownership is concentrated to a degree that one owner (or a few owners actingin concert) has effective control of the rm, the nature of the agency problem shifts away from manager–shareholder conicts. Information asymmetries can be assumed to be less, as the controlling owner isoften also the manager or can otherwise be assumed to be able and willing to invest the resourcesnecessary to closely monitor and discipline management. Rather, since insider-held rms dominate, theprincipal–agent problems in most countries around the world will be minority-versus-controllingshareholder. This means that the protection of minority rights matters most.

3.4. The diversity in group af liation and institutional investors

Many countries have large nancial and industrial conglomerates and groups. In some groups, a bank oranother nancial institution typically lies at the apex. These can be insurance companies, as in Japan (Mørckand Nakamura, 2007),orbanks,asinGermany(Fohlin, 2005). In other countries, and most often in emergingmarkets, a nancial institution is at the center of the group. Table A2 reports that many emerging marketcorporations are indeed part of business groups. For example, around 20% of all Korean listed companies aremembers of one of the 30 largest chaebols in this country. The fraction is even higher in India and Turkey.

Being part of a group can benet rms, particularly in emerging markets, since using internal factormarkets can overcome missing or incomplete external (nancial) markets. Groups or conglomerates canalso have costs, however, especially for investors. Worse transparency and less clear managementstructures provide scope for worse corporate governance, including expropriation of minority rights(Khanna and Yafeh, 2007 review; Masulis et al., 2011 present recent evidence for 45 countries). Indeedmuch evidence suggests that in the presence of a large divergence between cash-ow rights and votingrights, group-af liation has detrimental effects on stock valuation (Bae et al., 2008, forthcoming; Claessenset al., 2002; Joh, 2003; Lefort, 2005) and on operating performance (Bertrand et al., 2002).

Another aspect is the role of institutional investors. Studies on the role of institutional investors incorporate governance largely focus on the US (see Black, 1998; Gillan and Starks, 2003, 2007 for literaturereviews). Studies are focusing nearly exclusively on voting by mutual funds and related conict of interests (Ashraf et al., 2012; Davis and Kim, 2007) and the corporate governance of the funds themselves(Cremers et al., 2009). Ownership by institutional investors is generally small in emerging markets. Withthe typical dominant shareholder, institutional investors have little direct inuence – through voting,board representation or otherwise – and are more concerned about protecting themselves against

expropriation, rather than with disciplining management.Only a few studies examine institutional investor activism in markets with concentrated ownership

and business groups. Giannetti and Laeven (2009) nd some evidence of differences in voting betweenpension funds af liated with business and nancial groups and other pension funds in Sweden. McCaheryet al. (2010) nd large differences in preferences for activism between institutional investors in the U.S.and the Netherlands, countries which differ considerably in ownership structures. Yafeh and Hamdani(2011) report institutional investors in Israel to be active primarily when legally required to do so and tooften fail to use the legal powers granted. But studies for emerging markets specically are largely absent.

4. How and through what channels does corporate governance matter?

We organize the literature according to how and through what channels identied corporategovernance impacts corporations and countries as follows:

• The rst is the increased access to external nancing by rms. This in turn can lead to greaterinvestment, higher growth, and greater employment creation.





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• The second is a lowering of the cost of capital and associated higher rm valuation. This makes rmsmore attractive to investors, leading to growth and more employment.

• The third channel is better operational performance through better allocation of resources and bettermanagement. This creates wealth more generally.

• Fourth, good corporate governance can be associated with less nancial crises, important, as highlightedrecently again, given the large economic and social costs of crises.

• Fifth channel is that good corporate governance can mean generally better relationships with allstakeholders. This helps improve social and labor relationships and aspects such as environmentalprotection, and can help further reduce poverty and inequality.

All these channels matter for growth, employment, poverty, and well-being more generally. Empiricalevidence using various techniques has documented these relationships at the level of the country, thesector, and the individual rm and from the investor perspectives.3

4.1. Increased access to nancing

The role of legal foundations for nancial and general development is well understood and documented(see Ang, 2008; Levine, 2005; Rathinam and Raja, 2010; Rioja and Valev, 2004). Legal foundations mattercrucially for a variety of factors that lead to higher growth, including nancial market development, externalnancing, and the quality of investment. A good legal and judicial system is also important for assuring thebenets of economicdevelopmentthat are shared by many. Legal foundationsinclude property rights that areclearly dened and enforced and other key rules (disclosure, accounting, regulation and supervision).

Comparative corporate governance research documenting these patterns took off following La Porta etal. (1997, 1998). These two pivotal papers emphasized the importance of law and legal enforcement forthe governance of rms, development of markets, and economic growth. Numerous following studieshave documented institutional differences relevant for nancial markets and other aspects.4 Many otherpapers have since shown the link between legal institutions and nancial development (see Beck and

Levine, 2005 for a review).Studies have established that the development of a country's nancial markets relates to theseinstitutional characteristics and that these characteristics can direct affect growth. Beck et al. (2000)document how the quality of a country's legal system not only inuences its nancial development but alsohas a separate, additional effect on economic growth. In a cross-country study at a sectoral level, Claessensand Laeven (2003) report that in weaker legal environments, rms not only obtain less nancing but alsoinvest less than optimal in intangible assets. The less-than-optimalnancing and investment patterns in turnboth affect the economic growth of a sector. Acemoglu and Johnson (2005) nd that private contractinginstitutions play a signicant role in explaining stock market capitalization.

While seminal in its approach, LLSV's work and their initial indices of legal development andenforcement have been subject to a range of critical responses both on conceptual (Coffee, 1999, 2001a,2001b; Pagano and Volpin, 2005) and measurement grounds (Lele and Siems, 2007; Spamann, 2010).Partly in response, (Djankov et al., 2008b) present a new measure of legal protection of minorityshareholders: the anti-self-dealing index. Using this new measure they report that a high anti-self-dealingindex is associated with higher valued stock markets, more domestic rms, more initial public offerings,and lower benets of control. As such, the general nding that better legal protection helps with capitalmarket development is conrmed. Nevertheless, there remain some disagreements on how importantlegal aspects are as drivers of nancial sector development (see Armour et al., 2009).

3 Some of these studies suffer from endogeneity issues: while rms, markets, or countries may adopt better corporate governanceand perform better, the relationship is not from better corporate governance to improved performance; rather it is either the otherway around or because some other factors drive both better corporate governance and better performance. For discussions of theeconometric problems raised by endogeneity see Himmelberg et al. (1999), Coles et al. (2012), Adams and Ferreira (2008) and

Roberts and Whited (2011).4 All these applications are important, although not novel. Coase (1937, 1960), Alchian (1965), Demsetz (1964), Cheung (1970,1983), North (1981, 1990), and subsequent literature have long stressed how interactions between property rights and institutionalarrangements shape economic behavior. La Porta et al. (1997, 1998), however, provided the tools to compare institutionalframeworks across countries and study the effects in a number of dimensions, including how a country's legal framework affectsrms' external nancing and investment.



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This literature has shown that better creditor and shareholder rights are associated with deeper andmore developednancial markets. This relationship holds across countries and over time, in that countriesthat improved their creditor rights saw an increase in nancial development (Djankov et al., 2008b). Asimilar relationship exists between the quality of shareholder protection and the development of countries' capital markets. Most studies nd that these results are robust to include a wide variety of controlvariables in the analysis. Of course, it is not just the legal rules that count, but importantly their enforcement.In this context a well staffed and independent securities regulator becomes key ( Jackson and Roe, 2009).

In countries with better property rights, rms thus have a greater supply of nancing available, andrms invest more and grow faster (Rajan and Zingales, 1998). These effects can be large. For example,evidence suggests that countries in the third quartile of nancial development enjoy between 1 and 1.5extra percentage points of GDP growth per year, compared with countries in the rst quartile. There is alsoevidence that under conditions of poor corporate governance (and underdeveloped nancial and legalsystems and higher corruption), the growth rate of the smallest rms is the most adversely affected, andfewer new rms start up—particularly small rms (Beck et al., 2005).

There is also evidence on the importance of the cost of capital channel, both for equity and debtnancing. Chen et al. (2011) nd that U.S. rms with better corporate governance have a lower cost of

equity capital after controlling for risk and other factors, with effects stronger for rms that have moresevere agency problems and face greater threats from hostile takeovers. Ashbaugh-Skaife et al. (2004)report that rms with a higher degree of accounting transparency, more independent audit committeesand more institutional ownership have a lower cost of capital, whereas rms with more blockholders havea higher cost. Hail and Leuz (2006) show how legal institutions affect the cost of equity.

Attig et al. (2008) report for eight East Asian emerging markets that the cost of equity capital decreasesin the presence of large shareholders different than the controlling owner, suggesting that second largeshareholders help curb the private benets of the controlling shareholder and reduce informationasymmetries. Chen et al. (2009, 2011) nd that rm-level corporate governance signicantly lowers thecost of equity capital in 17 emerging markets. This effect is more pronounced in countries that providerelatively poor legal protection. Thus, in emerging markets, rm-level corporate governance and country-

level shareholder protection seem to be substitutes for each other in reducing the cost of equity. Byun et al.(2008) show that in Korea better corporate governance practices relate negatively to estimates of impliedcost of equity capital, with better shareholder rights protection having the most signicant effect, followedby independent board of directors and disclosure policy.

Sound governance has been shown to lower the cost of debt for US rms (Anderson et al., 2004). Lin etal. (2011) nd that the cost of debt nancing is signicantly higher for companies with more divergencebetween the largest ultimate owner's control and cash-ow rights. They show that potential tunneling andother moral hazard activities by large shareholders are facilitated by their excess control rights. Theseactivities increase the monitoring costs and the credit risks faced by banks and, in turn, raise the cost of debt.

Laeven and Majnoni (2005) nd that better higher judicial ef ciency and enforcement of debtcontracts are critical to lowering intermediation costs for a large cross-section of countries. Qian and

Strahan (2007) nd that stronger creditor rights result in loans with longer maturities and lower spreads.Bae and Goyal (2009) show that it is enforceability, not merely creditor rights, that matters to the cost andef ciency of loan contracting. Miller and Reisel (2012) report that bond contracts are more likely toinclude covenants when creditor protection laws are weak.

4.2. Higher rm valuation and better operational performance

The quality of the corporate governance framework affects not only the access to and the amount of external nancing, but also the cost of capital and rm valuation. Outsiders are less willing to providenancing and are more likely to charge higher rates if they are less assured that they will get an adequate

rate of return. Con

icts between small and large controlling shareholders –

arising from a divergencebetween cash-ow and voting rights – are greater in weaker corporate governance settings, implying thatsmaller investors are receiving too little of the returns the rm makes. Better corporate governance canalso add value by improving rm performance, through more ef cient management, better assetallocation, better labor policies, and other ef ciency improvements.





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There is convincing empirical evidence for these effects. Table A3 gives an overview of empirical analysesof the relationship between ownership structures and company valuations and operational performance.Firm value, typically measured by Tobin's q, the ratio of market to book value of assets, is higher when thelargest owner's equity stake is larger, but lower when the wedge between the largest owner's control andequity stake is larger (Claessens et al., 2002; Lins, 2003; Mitton, 2002). Large non-management control rights,blockholdings, are also positively related to rm value. These effects are more pronounced in countries withlowlegal shareholder protection (Pursey et al., 2009). Much evidence fromindividual countries such as Korea(Bae et al., forthcoming),HongKong(Lei and Song, 2008), Brazil, Chile, Colombia,Peru and Venezuela (Cueto,2008) conrms that less deviation between cash ow and voting rights is positively associated with relativerm valuation. This effect is substantial: a one standard deviation decrease in the degree of divergence isassociated with an increase in Tobin's q of 28% (an increase in stock price of 58%) in Chile. Similar effects arereported for Korea (Black et al., 2006) and Turkey (Yurtoglu, 2000, 2003).

The country and rm level studies suggest that better corporate governance improves marketvaluations. Two forces are at work here. First, better governance practices can be expected to improve theef ciency of rms' investment decisions, thus improve the companies' future cash ows which can bedistributed to shareholders. The second channel works through a reduction of the cost of capital which is

used to discount the expected cash ows. Better corporate governance reduces agency risk and thelikelihood of minority shareholders' expropriation and possibly leads to higher dividends, makingminority rights shareholders more willing to provide external nancing.

While fewer studies analyze operating performance than valuation, the ones that do, report in generalpositive effects when agency issues are less. Wurgler (2000) shows the general benecial role welldeveloped nancial markets play in the allocation of capital. In a cross-country empirical study, Claessenset al. (2010) show that the responses of investment to changes in Tobin's q are faster in countries withbetter corporate governance and information systems. A positive impact of foreign corporate ownershipon operating performance is documented by Douma et al. (2006) for India. Pant and Pattanayak (2007)nd that inside owners in India improve operating performance when ownership is smaller than 20% andgreater than 49%, suggesting entrenchment effects at intermediate levels.

For Taiwan, insider ownership is negatively and institutional ownership positively related to totalfactor productivity. Similarly for Taiwan, Yeh et al. (2001) nd adverse effects of entrenched owners.Filatotchev et al. (2005) document a positive impact of institutional investors and foreign nancialinstitutions ownership on performance. Orbay and Yurtoglu (2006) report a negative inuence of theownership-control disparity on investment performance in Turkey. Wiwattanakantang (2001) reportsthat controlling shareholders' involvement in management negatively affects performance in Thailand.Carvalhal da Silva and Leal (2006) for Brazil and Gutiérrez and Pombo (2007) for Colombia report higheroperating performance where owners have more cash ow rights and no ownership disparity.

Besides nancial and capital markets, other factor markets need to function well to prevent corporategovernance problems. These real factor markets include all output and input markets, including labor, rawmaterials, intermediate products, energy, and distribution services. Firms subject to more discipline in the real

factor markets are more likely to adjust their operations and management to maximize value added. Corporategovernance problems are therefore less severe when competition is already high in real factor markets.The importance of competition for good corporate governance is true in nancial markets as well. The

ability of insiders, for example, to mistreat minority shareholders consistently can depend both on thedegree of competition and protection. If small shareholders have little alternative but to invest in low-earning assets, for example, controlling shareholders may be more able to provide a below-market returnon minority equity.5 Open nancial markets can thus help improve with corporate governance, one of theso-called collateral benets of nancial globalization (Kose et al., 2010).

5 The role of competition in nancial development and stability is, however, still being debated (see the views of Thorsten Beckversus those of Franklin Allen in one of The Economist debates in June 2011). Theoretically, less competition can be preferable in a

second-best world if banks expand lending under stronger monopoly rights and thereby enhance overall output (Hellmann et al.,2000). Less competition may also lead to more nancial stability as nancial institutions have greater franchise value and acttherefore more conservative. On the other hand, competition leads to more pressures to reduce inef ciencies and lower costs, andcan stimulate innovation. Besides the benecial effects of reducing inef ciencies or weeding out corrupt lending practices oftenassociated with protected nancial systems, greater competition may also reduce excessive risk taking (Boyd and Nicoló, 2005) andpromote (implicit) investment coordination among rms (Abiad et al., 2008).



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Surprisingly, while well accepted and generally acknowledged (see Khemani and Leechor, 2001), thereis less empirical evidence on the role of competition in relationship to corporate governance. Guadalupeand Perez-Gonzalez (2010) show that within-country increases in the intensity of competition lead to areduction in the level and dispersion of private benets of control. Their results are more pronounced inweak-rule-of-law countries. In a paper on Poland, Grosfeld and Tressel (2002) nd that competition has apositive effect on rms with good corporate governance, but no signicant effects on rms with badcorporate governance. Li and Niu (2007) nd that moderate concentrated ownership and product marketcompetition are complementary in enhancing the performance of Chinese listed rms. They also reportthat competitive pressures can substitute for weak board governance. Bhaumik and Piesse (2004) observepatterns of change in technical ef ciency from 1995 to 2001 for Indian banks consistent with the notionthat competitive forces are more important than ownership effects. Estrin (2002) documents that weakcompetitive pressures played a pivotal role in the poor evolution of corporate governance in transitioncountries. Conversely, Estrin and Angelucci (2003) nd evidence that post-transition competitivepressures encouraged better managerial actions, including deep restructuring and investment.

4.3. Less volatile stock prices

The quality of corporate governance can also affect rms' behavior in times of economic shocks andactually contribute to the occurrence of nancial distress, with economy-wide impacts. During the EastAsian nancial crisis, cumulative stock returns of rms in which managers had high levels of control rights,but little direct ownership, were 10 to 20 percentage points lower than those of other rms (Lemmon andLins, 2003). This shows that corporate governance can play an important role in determining individualrms' behavior, in particular the incentives of insiders to expropriate minority shareholders during timesof distress. Similarly, a study of the stock performance of listed companies from Indonesia, Korea, Malaysia,the Philippines, and Thailand found that performance is better in rms with higher accounting disclosurequality (proxied by the use of Big Six auditors) and higher outside ownership concentration (Mitton,2002). This provides rm-level evidence consistent with the view that corporate governance helps explain

rm performance during a crisis.Related work shows that hedging by rms is less common in countries with weak corporate governance

frameworks(Lel, 2012), and to the extent that it happens, it addsverylittlevalue (Allayannis et al., 2009).Thelatter evidence suggests that in these environments, hedging is notnecessarily for thebenet of outsiders, butmore for the insiders. There is also evidence that stock returnsin emerging markets tend to be more positivelyskewed than in industrial countries (Bae et al., 2006). This can be attributed to managers having morediscretion in emerging markets to release information, disclosing good news immediately, while releasingbad news slowly, or that rms share risks in these markets among each other, rather than through nancialmarkets.

There is also country-level evidence that weak legal institutions for corporate governance were keyfactors in exacerbating the stock market declines during the 1997 East Asian crisis ( Johnson et al., 2000).In

countries with weaker investor protection, net capital inows were more sensitive to negative events thatadversely affect investors' condence. In such countries, the risk of expropriation increases during badtimes, as the expected return of investment is lower, and collapses in currency and stock prices are morelikely.

The view that poor corporate governance of individual rms can have economy-wide effects is notlimited to developing countries. In the early 2000s, the argument was made that in developed countriescorporate collapses (like Enron), undue prot boosting (by Worldcom), managerial corporate looting (byTyco), audit fraud (by Arthur Andersen), and inated reports of stock performance (by supposedlyindependent investment analysts) led to crises of condence among investors, leading to the declines instock market valuation and other economy-wide effects, including some slowdowns in economic growth.

Evidence from nancial crises suggests as well that weaknesses in corporate governance of nancial and

non-nancial institutions can affect stock return distributions. Consistently, Bae et al. (forthcoming) ndthatduring the 1997 Asian nancial crisis, rms with weaker corporate governance experience a larger drop intheir share values, but during the post-crisis recovery period, suchrms experience a larger rebound in theirshare values. And during the recent nancial crisis, rms that had better internal corporate governance tendto have higher rates of return (Cornett et al., 2009). Importantly, in the recent nancial crisis, corporate



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governance failures at majornancial institutions, suchas Lehmanand AIG, contributed to theglobalnancialturmoil and subsequent recessions. While this is more anecdotal evidence, it is clear that corporategovernance deciencies can carry a discount, either specic to particular rms or for markets as whole, indeveloped as well as developing countries, and even lead to nancial crises. As such, poor corporategovernance practices can pose a negative externality on the economy as a whole.

4.4. Better functioning nancial markets and greater cross-border investments

More generally, poor corporate governance can affect the functioning of a country's nancial marketsand the volume of cross-border nancing. One channel is that poor corporate governance can increasenancial volatility. When information is poorly protected – due to a lack of transparency and insidershaving an edge on rms' doing and prospects – investors and analysts may have neither the ability toanalyze rms (because it is very costly to collect information) nor the incentive (because insiders benetregardless). In such a weak property rights environment, inside investors with private information,including analysts, may, for example, trade on information before it is disclosed to the public.

There is evidence that the worse transparency associated with weaker corporate governance leads to

more synchronous stock price movements, limiting the price discovery role of stock markets (Mørck et al.,2000). A study of stock prices within a common trading mechanism and currency (the Hong Kong stockexchange) found that stocks from environments with less investor protection (China-based) trade athigher bid-ask spreads and exhibit thinner depths than more protected stocks (Hong Kong-based)(Brockman and Chung, 2003). Evidence for Canada suggests that ownership structures indicating potentialcorporate governance problems also affect the size of the bid-ask spreads (Attig et al., 2006). This behaviorimparts a degree of positive skewness to stock returns, making stock markets in well-governed countriesbetter processors of economic information than are stock markets in poorly governed countries.

Another area where corporate governance affects rms and their valuation is mergers and acquisitions(M&A). Indeed, during the last two decades, the volume of M&A activity and the premium paid weresignicantly larger in countries with better investor protection (Rossi and Volpin, 2004). This indicates

that an active market for mergers and acquisitions – an important component of a corporate governanceregime – arises only in countries with better investor protection. Also, in cross-border deals, the acquirersare typically from countries with better investor protection than the targets, suggesting cross-bordertransactions play a governance role by improving the degree of investor protection within target rms andaiding in the convergence of corporate governance systems.

A recent study by Bhagat et al. (2011) reports that emerging country acquirers experience asignicantly positive market response of 1.09% on the announcement day. These abnormal returns arepositively correlated with (better) corporate governance measures in the target country. Starks and Wei(2004) and Bris and Cabolis (2008) also report a higher takeover premium when investor protection in theacquirer's country is stronger than in the target's country. And Ferreira et al. (2010) show that foreigninstitutional ownership signicantly increases the probability that a local rm will be targeted by a foreign

bidder, with effects economically signicant: a 10 percentage point increase in foreign ownership doublesthe fraction of cross-border M&As (relative to the total number of M&As in a country). It also suggests thatforeign portfolio investments and cross-border M&As are complementary mechanisms in promotingcorporate governance worldwide.

4.5. Better relations with other stakeholders

Besides the principal owner and management, public and private corporations must deal with manyother stakeholders, including banks, bondholders, labor, and local and national governments. Each of thesemonitor, discipline, motivate, and affect the management and the rm in various ways. They do so inexchange for some control and cash ow rights, which relate to each stakeholders' own comparative

advantage, legal forms of inuence, and form of contracts. Commercial banks, for example, have a greateramount of inside knowledge, as they typically have a continued relationship with the rm. Formalinuence of commercial banks may derive from the covenants banks impose on the rm: for example, interms of dividend policies, or requirements for approval of large investments, mergers and acquisitions,and other large undertakings. Bondholders may also have such covenants or even specic collateral.





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Furthermore, lenders have legal rights of a state-contingent nature. In case of nancial distress, theyacquire control rights and even ownership rights in case of bankruptcy, as dened by the country's laws.6

Debt and debt structure can be important disciplining factors, as they can limit free cash ow and therebyreduce private benets. Trade nance can have a special role, as it will be a short-maturity claim, withperhaps some specic collateral. Suppliers can have particular insights into the operation of the rm, asthey are more aware of the economic and nancial prospects of the industry.

Labor has a number of rights and claims as well. As with other input factors, there is an outside marketfor employees, thus putting pressure on rms to provide not only nancially attractive opportunities, butalso socially attractive ones. Labor laws dene many of the relationships between corporations and labor,which may have some corporate governance aspects. Rights of employees in rm affairs can be formallydened, as is the case in Germany, France, and the Netherlands where in larger companies it is mandatoryfor labor to have some seats on the board (the co-determination model).7 Employees of course voice theiropinion on rm management more generally. And then there is a market for senior management, wherepoorly performing CEOs and other senior managers get red or good performing managers leave weaklyperforming corporations, that exerts some discipline on poor performance.

It is hard to give a denitive answer as to whether and which forms of stakeholders' involvement are

good for a corporation as a whole, let alone whether they are socially and economically optimal. There aremany aspects of stakeholders' involvement, with various consequences – for rm performance, valueadded, risk taking, environmental performance, etc. – and the overall net benets are often unclear givencurrent state of research. While, like for other aspects of corporate governance, some many studiesincreasingly often can clearly imply causality (as they use specic econometric techniques or study someevent that exogenously changes the institutional environment), some papers report only associations.What can be distinguished are two forms of behavior related to other stakeholders' role in corporategovernance issues: stakeholder management and social issue participation.

4.5.1. Stakeholder management

For the rst category, therm has no choice but to behave “responsibly” to stakeholders: they are inputfactors without which therm cannot operate; and these stakeholders face alternative opportunities if therm does not treat them well (typically, for example, labor can work elsewhere). Better employmentprotection can then improve the incentive structure and relative bargaining power of employees, and leadto more output. Acting responsibly toward each of these stakeholders is thus necessary. Acting responsiblyis also most likely to be benecial to the rm, nancially and otherwise.

Acting responsibly towards other stakeholders might in turn also be benecial for the rm's shareholdersand othernancial claimants. Arm with a good relationship with itsworkers, forexample, will probablyndit easier to attract external nancing. Bae et al. (2011) report that U.S. rms that treat their employees morefairly maintain lower debt ratios, i.e., are less risky nanced, in part since employees want to preserve their

job. This suggests that inside stakeholders can affect a rm's nancial policies. Collectively, a high degree of

corporate responsibility can ensure good relationships with all the rm's stakeholders and thereby improvethe rm's overall performance. Of course, the effects depend importantly on information and reputationbecause knowing which rms are more responsible to stakeholders will not always be easy. Ratings at acountry level, such as a ranking of the “best rms to work for,” can help in this respect.

6 Countries differ in this respect. In the United States, for example, banks are limited in intervening in corporations operations, asthey can be deemed to be acting in the role of a shareholder, and therefore assume the position of a junior claimholder in case of abankruptcy (the doctrine of equitable subordination). This greatly limits U.S. banks' incentives to get involved in corporategovernance issues as it may lead to their claim being lowered in credit standing. Other countries allow banks a greater role incorporate governance.

7

Employee ownership is of course the most direct form in which labor can have a stake in a

rm. The empirical evidence on theeffects of employee ownership for U.S. rms is summarized by Kruse and Blasi (1995). They nd that “while few studies individuallynd clear links between employee ownership and rm performance, meta-analyses favor an overall positive association withperformance for ESOPs and for several cooperative features”. A more recent study by Faleye et al. (2009) nds that labor-controlledpublicly-traded rms “deviate more from value maximization, invest less in long-term assets, take fewer risks, grow more slowly,create fewer new jobs, and exhibit lower labor and total factor productivity ”.



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4.5.2. Social issue participation

Recent years have witnessed a growing interest in corporate social responsibility (CSR) both fromacademia (Margolis and Walsh, 2003; McWilliams and Siegel, 2001; Orlitzky et al., 2003) and frombusinesses (see Accenture, 2010). This greater emphasis placed by rms on CSR activities can beinterpreted as a shift in the interaction between rms, their institutional environment, and importantstakeholders, such as communities, employees, suppliers, national governments and broader societalissues (Ioannou and Serafeim, 2010).

In spite of this greater involvement, whether participation in social issues also relates to good rmperformance is less clear. Involvement in some social issues carries costs. These can be direct, as whenexpenditures for charitable donations or environmental protection increase, andso lower prots. Costscanalsobe indirect, as when the rm becomes less exible and operates at lower ef ciency. As such, sociallyresponsiblebehavior could be considered “bad” corporate governance, as it negatively affects performance. (Of course, it can also be the case that government regulations require certain behavior, such as safeguarding theenvironment, such that the rm has no choice—although the country does. These are not considered here.)

The general argument has been that many of these forms of social corporate responsibility can still pay:that is, they can be good business for all and go hand in hand with good corporate governance. So while there

may be less direct business reasons to respect the environment or donate to social charity, such actions canstill create positive externalities in the form of better relationships with other stakeholders, signaling thevalue of products to buyers, or being seen as good citizens. The willingness, for example, of many rms toadopt high internationalstandards, such as ISO9000, that clearly go beyond the narrow interest of productionand sales, suggests that there is empirical support for positive effects at the rm level.

The general empirical ndings are of mixed evidence or no relationship between corporate socialresponsibility andnancial performance. As with many other corporate governance studies, the problem is inpart the endogeneity of the relationships. At the rm level, does good corporate performance beget bettersocial corporate responsibility, as the rm can afford it? Or does better social corporate responsibility lead tobetter performance? The rms that adopt ISO standards, for example, might well be the better performingrms even if they had not adopted such standards. At the coun

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