Corporate Governance and Company Valuation in Emerging Market Countries - Literature review Example

Corporate governance and company valuation in emerging market countries Table of Contents Overview 3 Corporate Governance and Company Value 4 Literature Review 4 Evidence from Russia 7 Evidence from India 9 Explaining the link 10 Corporate governance and board accountability – evidence from the emerging economy 11 Reference List 15 Overview The phrase of corporate governance did not gain prominence till the period of 1980’s. It was only during the 80’s the term gained worldwide attention. Initial attempts to define corporate governance were first observed by United Kingdom’s Cadbury report in 1992 and South Africa’s King Report in 1994. Later with the growing importance of the concept of corporate governance the formal definition of the term began emerging. Corporate Governance refers to the legal and the organizational framework under which the corporations work. They also include the processes and principles which are important in governing the business of any organizations. The concept of Corporate Governance has been initially been important for the multinationals of the developed countries. However, with the changing times the concept has been gaining importance in the companies of the developing countries as well (du Plessis, Bagaric and Hargovan, 2011). There has been a host of factors which have contributed to the growing importance of the corporate governance reforms like the Asian crisis of 1997 and the major corporate scandals. In the era of globalization, the rise of the businesses in the emerging countries has led to serious considerations regarding the corporate governance conditions prevailing in these countries. The purpose of this project is to understand the linking factor between the corporate governance and the value it generates for a company with particular reference to the emerging countries. A wide amount of academic literature has explored the relation between these two aspects. There is strong empirical evidence which connects the relation between these two aspects. It has been observed both in the context of developing and the developed countries that there is a strong relation between the two. Yet there is a clear demarcation of the intensity of the relationship between the two when it comes to the developing and the developed countries. There is a difference in the nature, direction, magnitude and processes of operation of the markets of the developing and the developed countries because of their differences in the economic, social and regulatory framework. This causes the intensity of relationship between value of company and corporate governance, vary in the developing and the developed countries (Bassen and Kleinschmidt, 2007). Corporate Governance and Company Value The literature on Corporate Governance suggests that the role of regulatory authority, board, suppliers and customers are important in improving the performance of a firm. The protection of the rights of the shareholders becomes an important responsibility of the companies and this underlines the signs of good corporate governance. In this context, it is important to describe the value of a firm. The value of a firm can be described as the utility or benefits that are derived by the shareholders of the firm by owning the shares of the company. The value of a firm is either studied by Value Ratio or Tobin’s q (Bassen and Kleinschmidt, 2007). The expression that relates the value of a firm to the corporate governance of a firm can be expressed by (Rashid and Islam, 2008): Value of firm= f (control variables, internal corporate governance variables, external corporate governance variables, error term) This expression clearly shows that if the internal and the external corporate governance of a country is good then this is going to improve the level of performance of the firms. This relationship has been tested empirically by a number of researchers and it has been found that the relationship is positive. However, it has been seen in the context of the developing countries that the relationship intensity varies slightly than the developed countries. The main problem lies in the fact that most of the theories try to use the theories of developed countries on the developing countries. However, it has been seen that in case of developing countries the results are not absolutely conclusive and differs from one country to another. This implies that the indicators of firm’s corporate governance and performance are not as linearly linked as it for the developed countries (Black, et al., 2008). Literature Review There is a growing body of literature that has studied the relationship between the two components. The magnitude of the studies has included the country level studies and firm-level studies regarding the topic. The cross country level of comparison has been conducted by Klapper and Love (2004) and Durnev and Kim (2005) to name a few. The single country study Balasubramaniam, Black and Khanna (2010) for India and Black, Love and Rachinsky (2006) for Russia to name a few. The parameters that are usually studied to measure the strength of corporate governance includes the accounting standards, stronger legal protection of investors and a stronger rule of law Generally it has been observed on a broad basis by most of the researchers that if the corporate governance is in the country is poorly organized in a manner that cannot protect the rights of the investor or protect the interest of the minorities then in such countries the performance of the firms are associated with poor performance. In a study conducted by Dowell, Hart and Yeung (2000) it has been observed that the if the firms in a country do not comply to the global standards of corporate framework then the values of those companies fall automatically. It can be stated that with the advent of globalization in the present era the level of integration between the economies has increased to a great extent. This means that the firms are now getting globally closer to one another. In this situation if the level of compliance to the corporate governance standards are poor then that firm is bound to lose its business. The work conducted by Klapper and Love have shown that the main risk comes from the risks associated with investments hamper the performance of the firms in emerging markets that are not under the protective shield of an efficient legal framework. In the work that has been conducted on single countries the experience of Korea has revealed that corporate governance is an integral factor that contributed largely to the development of the value of the public companies in Korea. The possible explanations for this cause and effect relationship between the corporate governance and value of a firm can be traced to the perception of the investors. It has been observed that if there is a conflict between the interests of those who control the firms differ widely from those who supply the firm with finances then it leads to a principal agent problem. This in turn adversely affects the performance of the firms. In this situation the principal (share holders and investor) thinks that the agent (company) is acting in order to maximize its own profit instead of working for the benefit of the investors (McEachern, 2012). The research work conducted by La Porta et al. (2000) emphasizes those firms operating in countries pay higher dividends where investors are better protected. Their work had also discovered that the slower growing firms tend to pay higher dividends than the firms which are growing faster. This implies that shareholders are willing to wait as the investment opportunities are good only when they are legally protected. On the other hand if it is found that the shareholders do not enjoy any legal protection will not want to wait no matter whatever be the investment condition is. The roots of this problem lie in the lack of transparency of the company in dealing with the shareholders and the inefficient regulatory framework. This in turn is directly related to the standard of corporate governance of the firm. It has been seen that in case of emerging countries these problems are endemic. This is because the level of social and economic conditions in these countries is not as properly regulated as in the developed countries. The research work of Perotti and Von Thadden (2003) have revealed that the corporate transparency have a positive implications on the value of the company. This is because when the investors are assured that their investments are safe with the company they are ready to keep their money with the company which in turn contributes to the growth of the company (Gibson, 2002). The level of transparency which includes timely reporting does not ensure that the business will not fail, it only ensures that the share holders are aware about the position of the company and most importantly the attention of regulators is attracted which restores faith in the investors. A well regulated Corporate Governance means that the investors in the companies will receive adequate returns on their performance. If the tools of the corporate governance are not functioning properly then this implies that the outside investors will find no interest to buy the services of the firms or act as a financier to the firm. The economic performance of the firm is likely to suffer under such a condition and the firm will lose its market value as it may miss lucrative business opportunities. The tight integration of the firms in today’s era will cause the temporary financial problem of one firm to spread to the other firms, employees and consumers. The works of Rajan and Zingales (1998) has shown that if the firms in only those countries are likely to develop more where the financial environment of the country is characterized by well regulated and stringent corporate governance. Not all works point in the same direction for the emerging markets. As has already been discussed that the emerging markets face a more complex situation and the relationship may always not be as clear as the developed countries. The main reason that can be propagated for this difference in the result is the fact the level of governance arrangements that are optimal for country may not be optimal for another country. This can be explained with the help of the following example. Suppose the level of ownership concentration that is likely to expropriate minority share holders in Brazil will not be the same in Argentina or any other developing country. Again it must be mentioned that most of the works that have been done in relation to the corporate governance has largely focused only on the developed countries. The non-availability of data in case of the developing countries makes it more difficult to study the phenomenon in these countries (Dallas, 2011). The research work conducted by Gibson (2002) has revealed that for one subset of firms in emerging countries there appears to be a strong relationship between the corporate governance and its performance but for another subgroup this result is not valid and the corporate governance is ineffective for these emerging market firms. These conditions are accentuated if there is a presence of large domestic shareholder in the company. If such shareholders are present in the company then the managers of the company tend to undermine the interest of the minority shareholders to promote the interests of the large shareholder (McCarthy, Puffer and Shekshnia, 2004). Under such a situation the link between the two weakens. Most of the research work has been based on certain specific characteristics of corporate governance on the value of a firm. This in turn have provided ambiguous results in certain cases where some aspects of corporate governance (like CEO Duality) has been found to exhibit a negative relation with the value of a firm and some aspects (like transparency) have been found to exhibit a positive relationship. It is extremely difficult to generalize the results for all the countries. It has been found that combination of a minimum number of outside directors and an audit committee staffed principally by outside director raises the value of at least for larger firms. The research of Black and Khanna (2007) found out that the results are not universal. The fact that greater disclosure leads to higher valuation have found strong grounds in the works of Black, Love and Rachinsky (2006) for Russia but same could not be confirmed by the research of Khanna and Black. Though theoretical research supports the Evidence from Russia Like in most of the developing countries the robust relationship between the corporate governance and the value of the firm has been observed in case of Russian firms as well. It has been observed that there is a direct link between the share price of firms in the emerging markets and the level of robustness of the corporate governance. It has already been established that there are various levels of study that has been conducted in this area. Some of them have addresses the firm-level corporate variance whereas other have dealt with industry-level. The research conducted at firm-level corporate governance has revealed that there is a positive relationship between the specific aspects of corporate governance such as audit committee, independent directors and minority shareholder protections and the level of the firm’s development (McCarthy, Puffer and Shekshnia, 2004). The study of firms in Russia has revealed that there is a clear connection between the share price and its governance. The most of the research works that has focused on the firm-level governance of emerging countries like Korea and Russia suffers from two major limitations. Firstly, most of these research works has been based on the usage of cross-sectional data of the firms. The research methodologies have been plagued by the omitted variable bias and imply that the correlation between the two may be spurious. The second limitation comes from the potential for the link between a governance index and share prices to reflect endogeneity, where higher-valued firms chose better governance and not the other way round. Few of these limitations were addressed by Black, Love and Rachinsky (2005) to study the corporate governance of the Russian firms. Their study had incorporated time-series data instead of cross-sectional data. The main findings from their study strongly indicate that there is a strong relationship and is in line with the previous studies in this regard. The level of corporate governance in Russia is definitely not homogenous in Russia. The Russian firms can be divided into four major groups: The level of corporate governance in these firms varies according to the group in which the company belongs. This can once again be associated with the level of performance of the firms. The privately owned firms in Russia have shown the least attempt to incorporate stable corporate governance in their system. This group is marked with maximum conflicts and lower performance. Based on the realization that there is a positive connection between the market value and the level of integration with the global economies the Russian firms have been incorporating the corporate standards. The business globalizers have a very high tendency for establishing proper corporate standards. For the investment seekers the level of improving the corporate governance arises from the desire to attract the investors. The management improvers belong to the group which is characterized by relatively weaker corporate governance and this group has reportedly lost their best managers as they prefer better corporate standards. The business localizers represent the group that is marked with almost negligible or no corporate governance primarily because they do not require any investments. The analysis of this structure reveals that those firms who want to operate on a global scale and attract investments have no other options but to rely on a developed legal structure and better governance to enhance their business. This in turn points out to the growing importance of corporate governance. Evidence from India In India as well there are various instances which prove that there is a positive relationship between the performance of a firm and the standard of corporate governance. However, like most other emerging countries the acceptance of corporate governance in India has not been extremely uniform. It has been observed that the large-scale companies only have been able to fully comprehend the importance of corporate governance in their business frameworks (Fernando, 2009). The works of Khanna and Palepu (1999) has concentrated on the development of reforms concerning corporate governance in India from the days of independence to the present. The works of Mohanty (2003) has revealed that investors are likely to hold the shares of only those companies which have well regulated corporate governance. The research conducted in this field has again been piecemeal and only a few characteristics were considered to predict the relationship. In some of the cases the statistical tools those were implemented were not exactly appropriate (Balasubramaniam, Black and Khanna, 2010). The research conducted by Varshney, Kaul and Vashal (2012) has confirmed that those companies which had confirmed that those firms which have adopted a stringent model of corporate governance have experienced a rise in the level of economic value added. One of the clear trends that have emerged from the study of the Indian market is that recently there has been a considerable rise in the incorporation of corporate governance in the recent years. The following table summarizes the time from which the various aspects of corporate services have existed for the company. Explaining the link The reasons which can be provided for the link between the variables are: Firstly, efficient corporate governance improves the asset allocation, labour practices and other efficient allocation which in turn improves the long term performance of a company. When the performance of a company improves its share price also improves and this contributes to the value of a company measured by Tobin’s q or any other related measures. Secondly, it has been found that agency problem will exert pressure on the stock price of a firm by impacting expected cash flows accruing to investors and the cost of capital. There are two major rationales behind this argument. Firstly, it is believed that if the investors anticipate that there will be a possible diversion of the company’s assets then the stock price of that company will reduce. Secondly, by reducing the shareholder’s monitoring and auditing costs good corporate governance is expected to reduce the return on equity and this would raise the valuation of the company in the long run. Thirdly, good corporate governance ensures that the company is free from any kind of fraud and malpractices. This aspect of corporate governance is guided by the code of best conduct which improves the level of performance of a firm in the business environment. This in turn helps the company to keep a clean name and it enhances the trust of the investors. If the investors have faith in the company they will continue to invest their money in the company and propels its future growth. This improves the value of the company. The fall of some of the largest foreign banks in the global financial crisis bears a testimony to the fact that the failure to govern the behaviour of individuals of a company can lead to its failure (Fernando, 2009). Fourthly, one of the major reasons that can be linked to the addition of value to a company through better corporate governance is the structure of the corporate in the contemporary business world. Most of the multinationals corporations in today’s world follow a structure where the ownership and the management of the companies are in different hands. This can potentially raise a doubt in the mind of the shareholders that whether the management is acting in their best interests. If they are assured that the management is strongly guided by a legal framework which will protect the assets of the investors then they establish long-term relation with the company which in turn promotes the performance and value of the company. Finally, if the shareholders and the investors are confident that the company will not squander their wealth or get involved in any kind of fraudulent activities then the value of a company is bound to improve. There has been a broad consensus, despite the differences in some of the theoretical works that all the companies which have improved their corporate governance have experienced a rise in their value. The improvement in the corporate governance leads to an improvement in the benefits that can be enjoyed by investors and this in turn leads to an improvement in the company’s value. Corporate governance and board accountability – evidence from the emerging economy Accounting is a fundamental concept in the field of corporate governance but it’s understood, practiced and researched diversely (Roberts, 2001; Brennan and Solomon, 2008). As mentioned earlier, an unprecedented level of augmentation has been witnessed in the number of quantitative studies done in the field of corporate governance and its implementation in emerging countries. Researchers have also commented on the likely impact of corporate governance on corporate performance and other transparency outcomes such as disclosing social or financial information voluntarily (Krambia-Kapardis and Psaros, 2006; Qu and Leung, 2006; Soobaroyen and Mahadeo, 2008). The empirical results drawn by the research scholars suggests that there has been an adoption of different corporate governance frameworks which led to an increase in the related disclosures which is one form of individual accountability (Shaoul, Stafford and Stapleton, 2012). However, it has been explained that disclosure does not always automatically entail that there has been a substantial improvement in the board accountability and that it can be used to communicate an emblematic message of compliance to satisfy external audiences (Ow-Yong and Guan, 2000). This is one fact that led researchers to do an in-depth analysis in order to assess the influence of the corporate governance framework on board accountability. A combination of documentary evidence, semi-structured interviews and participant observation was adopted by Uddin and Choudhury (2008) in order to study the corporate governance practices in Bangladesh. The author commented that listed companies in Bangladesh exhibit, how family oriented influence play a crucial role in determining the board composition. Companies which demonstrate non-family board membership are very less in number and arise mainly because of the pressure created by institutional investors and backs. However the directors of such companies do not bear a strong role or are independent in name. The nature of board meetings seems to be a mere formality precisely because decisions have already been made after discussions with sponsor directors who are the head of the family. The corporate sector in India is diverse in nature. On one hand it comprises of multinational corporations and on the other hand there is a large concentration of small and medium sized enterprises which drives the growth of the economy thereby strengthening the corporate sector. This robust mosaic of corporate India has been contributing significantly towards stimulating the economic growth of the country. In addition to that, the strong governance framework that exits in both small and large organizations is directed towards focusing on transparency, accountability, fairness and responsibility. The proper implementation of the framework is pivotal not only for assuring the vibrant and healthy corporate sector growth but also to ensure the all round development of the economy. The Ministry Of Corporate Affairs in the country has been working in close connection with the pioneers of the corporate sector in India in order to be able to fortify the corporate governance framework through a two pronged strategy. Some dimensions and aspects that are required to be included in the law have already been appended in the Company Bill, 2009 law which is now under examination conducted by the Parliament. However, keeping in perspective the intent of supporting the use of better practices a per the corporate governance code of conduct through voluntary adoption, the ministry along with the corporate sector has decided to outline a set controlled guidelines which will not only serve as a standard for the corporate sector but will also enable them to achieve a premier standard of corporate governance. Stakeholders who participated in a consultation conducted under the aegis of the National Foundation for Corporate Governance fully supported the idea of formulating voluntary guidelines on corporate governance. Efficient and sound corporate governance practices serve as the foundation that boosts the performance of companies which leads to the maximization of their operational efficiency as a result of attaining substantial productivity level and ensuring that the stakeholder’s interest are always safeguarded. The issue of corporate governance might go well further than law as well as the range of regulatory or regulatory framework. Keeping in mind the fact that has been mentioned above, it has been considered that drafting the voluntary guidelines, which covers different dimensions of corporate governance and are relevant in the present context of the field, is of utmost importance. After the guidelines are prepared they should be appropriately disseminated in order to render them worthy of being considered and adopted by the corporate sector in the country (Iyer, 2013). Given the fact that Russian managers have been operating in an institutional context that is bereft of a history of value maximization as far as the private sector is concerned, it seems more practical to draw a broader definition of corporate governance and accountability by taking into considering the condition that prevail in Russia instead of concentrating entirely on the slender agency problem accentuated in the West. A wider perception of corporate governance covers the ultimate objectives of maximizing value for the shareholders and also gives equal importance in order to ensure that the context of accountability is maximizing the value. This condition is pivotal to the development of a convincing system of corporate governance in Russia. Until and unless the context of transparence and accountability is attained an widely encouraged by the Russia’s institutional environments owners and agents of corporations, they will even be able to articulate and sustain the credible coordination necessary in order to create and maximize the value for all organizational plaintiffs. Thus it is this wider definition of corporate governance framework that puts a strong emphasis on developing a context of transparency and accountability within a corporation that underlies the perspective of the author. 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[pdf] SSRN Available at: [Accessed 28 January 2014]. Shaoul, J., Stafford, A. and Stapleton, P., 2012. Accountability and corporate governance of public private partnerships. Critical Perspectives on Accounting, 23, pp. 213-229. Read More