Firms in developed countries with English-origin legal systems are the best at
delivering returns on investment; firms in developing countries with civil law
systems are on average the worst performers. That is the conclusion of new
research by Klaus Gugler, Dennis Mueller and Burcin Yurtoglu, which
examines the impact of corporate governance structures – the sets of rules
determining the relationship (i.e. the rights and duties) between managers and
shareholders – on firms’ investment performance.
The study, published in the November 2003 issue of the Economic Journal,
provides estimates of ‘marginal q’ – the ratio of rates of return on investment
to companies’ cost of capital – for a large sample of countries. A firm’s
investment maximises the value of the company, when the returns on
investment equal its cost of capital, and marginal q equals 1.0.
For developed countries, the researchers estimate a marginal q of 0.97 – very
close to the optimal value. In contrast, the estimate for developing countries is
only 0.77.
These estimates imply a substantial difference in investment performance
between developed and developing countries. Firms in developing countries
are making poorer investment choices than in developed countries and/or
investing more than is optimal from the point of view of the shareholders.
The authors interpret this difference as being consistent with corporate
governance institutions in developing countries affording managers more
discretion to pursue their interests at their shareholders’ expense. The most
plausible goal of these managers is the pursuit of growth of the company,
which – driven too far – clashes with the goal of profitability.
The legal institutions of a country also have a significant impact on investment
performance. Common law systems are much better at aligning managers’
and shareholders’ interests than are civil law systems. Marginal q is 1.02 for
16 countries with English-origin legal systems, and only 0.68 for 30 countries
with civil law systems. This dramatic difference implies that a pound invested
in an Anglo-Saxon country creates assets with a value of roughly a pound,
while a euro invested in a civil law country creates assets with a value of only
68 cents.
This difference in investment performance helps to explain why the
economies of continental European countries have performed poorly in recent
years relative to Britain, the United States and several other Anglo-Saxon
countries. Differences in corporate governance systems have led to less
productive investment by large and listed corporations in the civil law
countries.
The results also help to explain the seemingly paradoxical finding that
companies in some developing countries make more use of external capital
markets to finance investment, despite the fact that capital markets are far
broader and more sophisticated in developed countries.
The authors find that only the companies in developing countries that are
making poor investments make heavy use of the equity market to finance their
investments. Equity markets in developing countries do not appear to
constrain managers who seek funds for poor investments as well as they do
in developed countries.
The research also tests for the impact of some specific institutions of
corporate governance. The returns on investments out of cash flows and new
equity are higher in countries with strong accounting standards than in
countries with weak standards. The returns on investments out of cash flows
and new equity are also higher in countries with better contract enforcement.
Thus, countries seeking to strengthen their corporate governance systems
and improve the investment performance of their corporate sector can do so
by strengthening their accounting practices and improving contract
enforceability.
Particularly revealing is the finding that no developed country with an Englishorigin
legal system has weak accounting standards, and no developing
country with a civil law system has strong contract enforceability.
These differences both underscore the importance of corporate governance
institutions in explaining investment performance, and help explain why
developed countries with English-origin legal systems are the best
performers, while the developing countries with civil law systems are on
average the worst performers.
ENDS
Notes for Editors: ‘The Impact of Corporate Governance on Investment
Returns in Developed and Developing Countries’ by Klaus Gugler, Dennis
Mueller and Burcin Yurtoglu is published in the November 2003 issue of the
Economic Journal.
The authors are at the University of Vienna.
For Further Information: contact RES Media Consultant Romesh Vaitilingam
on 0117-983-9770 or 07768-661095 (email: romesh@compuserve.com); or
Burcin Yurtoglu on +43-1-4277-37482 (email: burcin.yurtoglu@univie.ac.at).