Variation in firms’ corporate governance is an important topic of debate in the governance literature. One of the main questions is whether weak and/or incomplete public institutions in emerging economies dictate the governance quality of local firms. The most recent scholarship on the subject has generally argued that country characteristics strongly predict governance (Krishnamurti, Sevic, and Sevic (2006)). Doidge, Karolyi, and Stulz (2007) find that country variables explain 39-73% of governance variance while firms explain only 4-22%. Moreover, they argue that firm characteristics explain almost none of the governance variation in “less-developed countries.” In our paper, Which Does More to Determine the Quality of Corporate Governance in Emerging Economies, Firms or Countries?, which was recently made publicly available on SSRN, we offer a new understanding of firm and country characteristics’ contribution to emerging economies’ governance.
Corporate governance fuels growth by providing investors an assurance of a return on their investment (Shleifer and Vishny (1997)). Investors are more willing to offer valuable financing or pay a higher equity price for firms with better governance (Chen, Chen and Wei (2009)). This financing is critical to growing a firm’s value. In short, higher corporate governance ratings are causally related to higher firm value (Black, Jang, and Kim (2006)). Corporate governance should, therefore, be important in emerging economies where firms are forced to rely on outside investors to help finance growth opportunities.
To test this intuition, we apply variance decomposition to corporate governance ratings in emerging and developed economies. Across two main data sets, in emerging economies, we find that firm characteristics explain 37.3-50.3% of the corporate governance ratings’ variance, and country characteristics explain roughly 11-28.5% of the variance. In developed economies, a different pattern is found. Observable and unobservable firm characteristics explain only 15.3-19.1% of governance ratings variance in developed economies while country characteristics explain 45.9-57.3%. Therefore, in emerging economies, firm variables explain roughly the same amount and often more of the governance variance than do country variables. In developed economies, in contrast, country variables explain significantly more of the corporate governance ratings than do firm variables.
We improve on previous cross-sectional studies by using a panel of data across multiple years and multiple countries. We use three corporate governance ratings datasets covering large parts of the last decade. We also improve on previous work by expanding the original set of observable firm characteristics analyzed. This original set of firm characteristics includes five observable variables such as sales growth and cash/assets. We identify 17 additional firm variables that are prescriptive of firm corporate governance choices. Lastly, our methodology improves on that of previous studies by accounting for the nested nature of the data. As firms are necessarily embedded within countries, it is impossible to run analyses on firms alone and not simultaneously capture some of the country effect. Running our models successively, and adding in firms and years separately gives us an accurate measure of what firm characteristics alone are contributing to governance variance.
Our results provide evidence that many emerging economy firms distinguished themselves above and beyond their home country peers in corporate governance ratings during the last decade. This rise was due primarily to firm-level characteristics, the most important of which are unobservable. The fact that firm characteristics, and especially fixed effects, played a substantially greater role in emerging economies suggests that there is something happening inside these firms that allowed them to differentiate themselves from their home institutions and peer firms. These findings are important for both investors and firms in emerging economies. Investors will be able to observe corporate governance variance within countries and identify valuable investment opportunities. Also, firms should enjoy a sense of agency in their prospects for growth, unhampered by an environment with weak and incomplete governance institutions or low financial market development. While the country in which the firm is based is still important, there is agency beyond location for firms.
The full paper is available for download here.