FIRMS’ INVESTMENT PERFORMANCE: THE IMPACT OF CORPORATE GOVERNANCE

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 English-origin 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).