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Simon Johnson and Andrei Shleifer
Privatization is at the top of the political agenda in Asia. In China, the state sector has failed to wither and continues to consume a large amount of state resources (Steinfeld 1998, 2000). In Korea, the state has acquired substantial banking assets through bailout programs and now faces the serious issue of how to dispose of these assets (Chopra et al. 2001). In Malaysia, there is the beginning of a real discussion about how best to manage the relationship between the state and previously state-owned enterprises (Gomez and Jomo 1998). Throughout Asia, strong interest is developing in whether further privatization will speed up the economic recovery and sustain growth.
The early enthusiasm for privatization, however, has worn off since the 1980s and there is a general feeling of caution. Recent experience, particularly in Eastern Europe and the former Soviet Union, has demonstrated that simply privatizing is often not enough. As a result, there is a new emphasis on various complementary measures, such as stimulating competition. These complementary measures are often quite distinct from privatization itself and require separate political initiatives. In this paper we focus on one important issue that has emerged over the past decade: corporate governance of privatized firms.
Privatized firms with weak corporate governance have repeatedly demonstrated weak performance and have frequently been "tunneled" by their management. In the Czech Republic, management of newly privatized firms conspired with the managers of investment funds to strip assets and siphon off cash flow (Coffee 1999b). Belated attempts by the Czech authorities to control this process have proved difficult. The lesson from post-communist countries is that effective investor protection must accompany privatization.
But how exactly should corporate governance be implemented? In particular, is it necessary or even helpful for the government to pass and enforce laws or legal regulations? Or can the private sector achieve all its desired outcomes simply by relying on private contracts, in which case all the government needs to do is to ensure that such contracts are enforced?
Ronald Coase (1960) explained the conditions under which individuals and private firms should be able to make contracts as they please. As long as the enforcement costs of these contracts are nil, individuals do not need statutory law or can find ways to contract around the law. There remains strong support in both law and economics for three important Coasian positions: law does not matter; law matters, but other institutions adapt to allow efficient private contracts; and finally, while law matters and domestic institutions cannot adapt enough, firms and individuals can write international contracts that achieve efficiency.
Coasian arguments have had great influence on discussions about corporate finance, and in this paper we focus on this literature, emphasizing points that seem particularly relevant for thinking about privatization. In the spirit of this general position, Easterbrook and Fischel (1991) argue that firms wishing to raise external finance can commit themselves to treat investors properly through a variety of mechanisms. Law may restrict the scope of these mechanisms, but firms and investors can always reach efficient arrangements. If this view is taken to the extreme, all countries that have a good judicial system should be able to achieve similar and efficient financial arrangements for firms. In this view, all privatization needs to do is to transfer property rights to private investors and the market will take care of the rest.
Also in the Coasian spirit, Berglof and von Thadden (1999) argue that civil-law countries in Europe have developed institutions that allow companies to enter enforceable contracts with investors. In their view, law may matter and have shortcomings, but the political process and firm-specific actions can generate other ways of offering effective guarantees to investors-for example, by mandating certain forms of government intervention or establishing a particular ownership structure and dividend policy. As a consequence, bringing U.S.-type institutions into Europe would not be helpful and could even be disruptive. In this view, the arrangements may differ across countries, but in many cases firms should be able to access external finance. The implication is that while privatization should be accompanied by institution building of some form, it does not need U.S.-style investor protection in order to be effective.
Even among the scholars who are convinced that legal rules matter, there is a Coasian skepticism about whether changing rules can have large effects. Coffee (1999a, b) argues that while U.S. firms derive important advantages from the U.S. legal system, other countries are not converging through changing their rules, presumably because this is politically difficult. Instead, there is a process of "functional" convergence, through which firms choose to adopt U.S.-type private contracts with their investors-for example, by issuing American Depositary Receipts (ADRs). In this view, corporate governance of privatized firms can be assured through the issue of ADRs or through otherwise listing in a stock market with a high level of investor protection.
These Coasian arguments are extremely powerful. However, they are rejected by the data. Recent research shows that the legal rules protecting investors matter in many ways, that other institutions cannot adapt sufficiently, and that changing domestic legal rules can have a big impact. We are also moving closer to a theoretical understanding of why exactly these Coasian positions are not correct and what this implies for standard models of economics and finance. The implication is that unless privatization is accompanied by enforceable investor protection, its benefits for firm performance will be limited because of severe agency problems, including various forms of expropriation or "tunneling" by management.
The evidence that legal rules matter is overwhelming. Protection of minority shareholders is weaker in countries with a civil law tradition. In many countries, the judiciary cannot be counted on to enforce contracts between investors and firms. Countries with less protection for minority shareholders have smaller equity markets, other things equal (La Porta et al. 1997a). Firms in countries with less investor protection use less outside finance (La Porta et al. 1997a) and have higher debt-equity ratios, making them more vulnerable to collapse (Friedman, Johnson, and Mitton 2003). Countries and companies with weak corporate governance can also suffer larger collapses when hit by adverse shocks (Johnson, Boone, et al. 2000; Mitton 2002; Lemmon and Lins 2003). Countries with weaker institutions have experienced greater output volatility over the past forty years (Thaicharoen 2001) and have suffered larger exchange rate crises (Pivovarsky and Thaicharoen 2001).
Other domestic institutions can adapt to some extent, but not enough to offset weak legal protection. The government has only limited ability to act directly to compensate for weak investor protection. Private companies in civil-law countries have developed various mechanisms to improve their investor relations, but these mechanisms are far from perfect. In many civil-law countries there are significant loopholes through which value can be tunneled legally out of a company (Johnson, La Porta, et al. 2000). An important complement of effective privatization is the effective legal protection of investors.
Laws and other institutions providing investor protection are persistent and hard to change. But this does not mean that legal reform is ineffective. Among countries with relatively weak legal systems, the evidence indicates that strong stock market regulation can to a large degree act as an effective substitute for judicial enforcement of contracts (Glaeser, Johnson, and Shleifer 2001). Poland provides a clear example of conditions under which a strong, independent stock-market regulator can create a well-functioning stock market, despite a weak judiciary. In all the success cases of capital market development and privatization through public sale of shares, good legal rules are of paramount importance.
Shleifer and Vishny (1997b) review the literature on corporate governance before the recent wave of findings from comparative research. La Porta et al. (2000b) describe the first wave of this research, which constitutes about twenty papers written through the early fall of 1999. However, the pace of activity in this area is accelerating. We cover about thirty new papers not included in either of these previous surveys.
Sections 1.2, 1.3, and 1.4 review the evidence against each of the Coasian positions, with particular emphasis on recent experience with privatization. Section 1.5 reports recent theoretical analysis based on this evidence. Section 1.6 concludes.
1.2 Law Matters
The strongest Coasian position is that law does not matter. If this were true, we should expect to see no significant correlation between legal rules and economic outcomes around the world. The evidence decisively rejects this hypothesis.
1.2.1 Investor Protection
The new literature on the importance of law begins with La Porta et al. (1998), who show there are systematic differences in the legal rights of investors across countries. An important explanatory factor of these differences is the origin of the legal system.
La Porta et al. (1998) propose six dimensions to evaluate the extent of protection of minority shareholders against expropriation by the insiders, as captured by a commercial code (or company law). First, the rules in some countries allow proxy voting by mail, which makes it easier for minority shareholders to exercise their voting rights. Second, the law in some countries blocks the shares for a period prior to a general meeting of shareholders, which makes it harder for shareholders to vote. Third, the law in some countries allows some type of cumulative voting, which makes it easier for a group of minority shareholders to elect at least one director of their choice. Fourth, the law in some countries incorporates a mechanism which gives the minority shareholders who feel oppressed by the board the right to sue or otherwise get relief from the board's decision. In the United States, this oppressed minority mechanism takes the very effective form of a class action suit, but in other countries there are other ways to petition the company or the courts with a complaint. Fifth, in some countries, the law gives minority shareholders a preemptive right to new issues, which protects them from dilution by the controlling shareholders who could otherwise issue new shares to themselves or to friendly parties. Sixth, the law in some countries requires relatively few shares to call an extraordinary shareholder meeting, at which the board can presumably be challenged or even replaced, whereas in other cases a large equity stake is needed for that purpose. La Porta et al. (1998) aggregate these six dimensions of shareholder protection into an anti-director rights index by simply adding a 1 when the law is protective along one of the dimensions and a 0 when it is not.
The highest shareholder-rights score in the La Porta et al. (1998) sample of forty-nine countries is 5. Investor protection is significantly higher in common-law countries, with an average score of 4, compared with French-origin civil-law countries, with an average score of 2.33. There is significant variation within legal origin, however. In the La Porta et al. data, there is no association between a country's level of economic development and its anti-director rights score, but a strong association between the score and the size of its stock market relative to gross national product (GNP).
La Porta et al. (1998, 1999) also find that the legal enforcement of contracts is weaker in countries with a civil-law tradition. For example, the efficiency of the judicial system on average is 8.15 in English-origin countries (on a scale of 1 to 10, where 10 means more efficient), but only 6.56 in French-origin countries. Legal origin therefore affects investor protection both through the rights available in the laws and the ease of enforcement of these rights.
Glaeser, Johnson, and Shleifer (2001) look in more detail at Poland and the Czech Republic, which were not included in the original La Porta et al. (1998) sample. They find that the Polish commercial code protected investors more than did the Czech code, but the most important difference was in the design and implementation of securities law. As Pistor (1995), Coffee (1999a), and Black (2000) also argue, protection under the commercial code is complementary to protection under securities law.
Slavova (1999) extends the La Porta et al. (1998) work to twenty-one formerly communist countries of Eastern Europe and the former Soviet Union. Rather than looking directly at the laws, she uses a survey to ask local legal professionals what specific rules are in place and how they are enforced. Her work confirms the analysis of La Porta et al. on the general relationship between shareholder protection and stock market development and the detailed assessment of Glaeser, Johnson, and Shleifer (2001) on Poland and the Czech Republic. For postcommunist countries, privatization has proved much more effective where capital markets have also developed at least to some extent.
Recent research has focused on some additional determinants of investor protection (Bebchuk and Roe 1999; Roe 2000, 2003; Stulz and Williamson 2003). Rajan and Zingales (2003) maintain that there is an important underlying political process. Berkowitz, Pistor, and Richard (2003) argue that the way in which legal systems were transplanted to other countries is more important than legal origin. However, Acemoglu, Johnson, and Robinson (2001) confirm that legal origin has explanatory power with respect to current institutions. They find that additional explanatory power lies with the way in which countries were colonized, and particularly whether the disease environment favored early settlers, but legal origin remains important. Using the pattern of colonization to generate a set of plausible instrumental variables, they show that institutions have a major impact on gross domestic product (GDP) per capita today (see also Acemoglu, Johnson, and Robinson 2002).
Measures of investor protection matter for economic outcomes. There is a direct effect of investor protection on the development of external capital markets. Both stock markets and debt markets are less developed in French origin countries (La Porta et al. 1997a). This is evident both in outside capitalization (measured as market capitalization owned by outsiders relative to GNP), domestic listed firms per capita, and initial public offerings per capita. For a sample of the largest firms in each country in 1996, La Porta et al. (1997a) find that French legal origin countries have significantly lower market capitalization relative to sales and to cash flow.
Subsequent work has found that lower stock market development can reduce growth (Levine and Zervos 1998), that financial development is correlated with growth (Beck, Levine, and Loayza 2000), and that the availability of external finance determines whether a country can develop capital-intensive sectors (Rajan and Zingales 1998a). Wurgler (2000) finds there is a better allocation of capital to industries in countries with more financial development.
Excerpted from Governance, Regulation, and Privatization in the Asia-Pacific Region Copyright © 2004 by National Bureau of Economic Research. Excerpted by permission.
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