10-1 Governance and Profitability Around the World Vince Hooper, Ah Boon Sim and Asfandyar Uppal School of Banking and Finance The University of New South Wales Sydney, NSW 2052 Australia

10-2 Governance and Profitability Around the World Abstract The purpose of this paper is to examine the effect of governance environments upon aggregate dividend yield and earnings per share for developed and emerging stock markets over the time period January 1995 to December Using an augmented version of the dividend growth model and allowing for the control of risk factors, we find that governance environments have a significant influence upon dividend yield and earnings per share. The results have policy implications for government policy setters as improvements to governance environments may induce portfolio equity inflow, which is increasingly being seen as a driving force for economic growth.

10-3 Literature Review F Return on Equity as Dividend Yield: Bekaert and Harvey (2000), Errunza and Miller (2000) F La Porta et al (2000). Countries with better investor protections should have higher dividend yields F Earnings-Price ratio is also a fundamental performance valuation ratio [captures both dividends and capital gain] F Klapper and Love (2002) find a high degree of correlation between firm level corporate governance and countries with good effective legal systems F Lombardo and Pagano (2000) argue that the profitability of projects is an positively related to efficiency of legal institutions

10-4 Data Sources: Stock Market F 50 developed and developing countries in our sample F Stock Market Indices Sourced from Morgan Stanley (MSCI $US Value Weighted). These indices are adjusted for dividends and market capitalization changes F MSCI World Index used as a proxy for the World Market Portfolio F Time Period: January 1995-December 2002

10-5 Data Sources: Accounting Ratios F Accounting ratios downloaded from Datastream F Price earnings ratio is defined as the “weighted average price/earnings ratio based on 12 month forward” F Dividend yield is defined as the “weighted dividend yield based on the indicated annual dividend” F The yield on domestic 10year government bond (from Datastream) is the local benchmark bonds

10-6 Data Sources: Governance Data F Governance Data is sourced from World Bank [Kaufmann, Kraay and Mastruzzi 2003 “Governance Matters III: Governance Indicators for ” F Four “clusters”: Voice and Accountability (VA) Political Stability and Absence of Violence (PS) Government Effectiveness (GE) Regulatory Quality (RQ) Rule of Law (RL) Control of Corruption (CC)

10-7 Methodology F Gordon Model

10-8 F Where E t is the expectation conditional on information known at time t, D i,t+j is the dividend paid out by the companies listed in country i at time t+j, and k i,t+j is the per-period risk-adjusted discount factor between time t and t+j relevant for the stream of dividends from country i. A simple version of the Gordon model assumes k i to be constant and where D i,t is the current dividend and g i D is a constant dividend growth rate specific to country i. Under these assumptions, the expected dividend yield becomes:

10-9 F [Equation 2]

10-10 F To calculate the risk-adjusted required rate of return k i, a model of the equilibrium determination of the rates of return on stocks with different risk characteristics is required. In an international CAPM framework, the systematic risk of stock market index i, is only due to its covariance with the world market [Sharpe (1964)]. When the required rate of return k i on equities also depends on the governance variables ki, may be written as [Equation 3]:

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10-20 F Figure 1: Description of Global Risk Factors F WRDRET: continuous return US dollar return of the MSCI world equity market in excess of the one-month US treasury bill rate. Source: MSCI Data available through Datastream. F G10FX: log first difference in the weighted average of the foreign exchange value for the US dollar against a subset of the broad index currencies that circulate widely outside the country of issue. Source: Federal Reserve Bank of St. F G7UI: unexpected component of monthly global inflation, derived from an ARIMA model applied to the log difference of the G7 weighted CPI’s, using the shares of the total real gross domestic product. Source: Datastream (mnemonic=G7OCP009F). F OIL: change in the monthly average OPEC oil basket price in US dollars. Source: Datastream (mnemonic= OILOPEC). F G7IP: weighted average of industrial production growth rates in the G7 countries where a measure of relative production shares is used as the weights. Source: Datastream (mnemonic=G7OPR035G).

10-21 Results Table 1 F Panel A, all measures of governance are found to be significantly and positively associated with dividend yields (except RL which does not have a positive co-efficient) F Panel B indicates that the quality of governance has a positive impact on dividend yields in both civil and common law countries

10-22 Results Table 2 F VA indicator has a positive effect upon Price-Earnings Ratio F All indicators are positive but insignificant F Results generally indicate that quality of governance positively affects the profitability of firms F Panel B highlights the importance of governance in environments with lower levels of investor protection to be more pronounced

10-23 Conclusion