1 How Poor Corporate Governance Leads to Country-Level Problems Simon Johnson Sloan School of Management, MIT and NBER

2 Roadmap 1) Defining corporate governance 2) Implications for: –Economic prosperity (growth) –Financial development –Crises and collapses 3) Solutions –New rules –New regulators –New markets

3 What Is Corporate Governance? Institutions that protect investors against expropriation –rule of law (constraint on government) –corporate governance (constraint on management) Corporate governance is –Partly country-level rules –Partly the result of firm-level decisions

4 The Main Ideas Private contracts alone do not provide enough protection to investors The legal system matters –“Investor protection” higher for countries with common law tradition (LLSV 1999a) –this affects macroeconomic outcomes Legal change is difficult in general –But securities markets can be improved (and worsened) more quickly

5 Implications for Growth Countries with stronger “institutions” (protection against expropriation) have grown more over the last 400 years: –One test: Look at the set of former colonies (AJR, 2000 and 2001) –Early institutions (good and bad) have persisted and account for 25% of variation in current institutions –We can use this to isolate the effects of current institutions

6 Implications for Financial Development There is more than one way to build strong “institutions” that protect investors –US-type institutions are not necessary or sufficient –e.g., can use have more concentrated ownership, bigger role for government banks (LLS 1999, LLSV 1999c ) But countries with stronger investor protection have larger equity markets (LLSV 1997a) –use more debt when weaker shareholder protection

7 Implications for Crises Weak institutions => larger exchange rate and output collapses –Consider largest crises, Weak institutions => higher short-term corporate and government debt in foreign currency –Compare effects of a large exchange rate depreciation in Europe and in emerging markets today

8 What Happened in South-East Asia during ? An initial macroeconomic shock => small loss of confidence Companies moved cash (sometimes assets) from public to private companies (e.g., to cover their debts). The emphasis was on preserving the core family assets, which are almost always privately held. Some of these companies failed because of actions by controlling management (e.g., finance houses and smaller banks in Thailand).

9 Can the Crisis be Explained? Not by standard hypotheses a) debt/budget deficits/current account b) credit growth/financial system Corporate governance is a more powerful explanation –across countries: shareholder rights, effectiveness of judiciary, corruption –within countries (Mitton, Lemmon & Lins)

10 Role of Corporate Governance Large companies in “emerging markets” (with few exceptions) are: –multi-sector conglomerates comprising public and private firms –key assets are held privately by controlling shareholder/family (with majority de facto voting rights) –heavy reliance on debt Corporate governance institutions are weak Effective protection of minority shareholders and creditors is limited

11 Role of Corporate Governance These institutions affect risk assessment by local and foreign investors –Investors ask, “If the economy is hit by a shock... “...will the government will take from business?” (lack of fiscal discipline, corruption) “...will management will take from shareholders?” (corporate governance)

12 Role of Corporate Governance Economic growth, return to shareholders, etc. Distribution of outcomes Standard view Our view

13 Role of Corporate Governance Contrast Indonesia in and Brazil in : –Both took an initially large shock (depreciation of the exchange rate; small loss of confidence) –Brazil stabilized because capital flowed in (Brazil looked cheap) –Indonesia crashed because capital flowed out (Indonesia looked corrupt/assets did not look cheap)

14 Implications for Today Economies in distress can rebound fast –But they remain vulnerable to collapse And parts of local blue chip companies can fail (but main activities will continue…) Current growth estimates for these countries are probably too low! –But they also underestimate the collapse potential

15 Solutions (A): New Rules Types: –Commercial law: affects all firms –Securities law: affects publicly traded firms Issues: –is there transparency of reporting, e.g., quarterly, informative (Germany)? –do intermediaries have a responsibility to protect investors (Poland)? –can shareholders bring lawsuits against management and/or large shareholders? CHANGING THE DETAILS IS IMPORTANT

16 Solutions (B): New Regulators Regulators can be given higher-powered incentives than judges (but danger of abuse) US case –SEC can decide who is listed and issue/withdraw licences –Regulation of intermediaries delegates information gathering (Landis’ idea for the US) –Appeal to court is time consuming; longer delays actually strengthen the SEC Poland vs. Czech Republic

17 Solutions (C): New Markets Existing firms likely oppose changes in existing securities rules and regulators Creating new market offers way for firms to raise capital on different terms –Ex: German Neuer Markt requires compliance with NASDAQ-type rules –Creates opportunities for new firms, improves access to venture capital –Puts pressure on existing markets to improve rules (spread of NASDAQ trading around the world)

18 Conclusion Corporate governance and investor protection matter for financial development and economic prosperity Growth is possible with weak institutions, tending to favor large incumbents/powerful families But crises are larger and more persistent when institutions are weaker (particularly when open to capital flows) Securities markets can be reformed to better protect investors New rules are essential, new regulators are helpful, new markets are possible almost everywhere This is a first-order macroeconomic issue