Academic journal article Financial Management

National Culture and Profit Reinvestment: Evidence from Small and Medium-Sized Enterprises

Academic journal article Financial Management

National Culture and Profit Reinvestment: Evidence from Small and Medium-Sized Enterprises

Article excerpt

We examine the role of national culture--an important informal institution--in the profit reinvestment decisions of small firms in emerging markets. Prior economic development literature focuses on formal institutions as determinants of growth. However, in emerging markets where formal institutions are less developed, informal institutions should have more of a direct versus indirect impact through formal institutions. We find that Schwartz's cultural dimensions of Embeddedness and Hierarchy negatively affect profit reinvestment, and that access to external financing (strength of property rights) is more important for reinvestment decisions in countries with low (high) Embeddedness and Hierarchy.

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What factors contribute to economic development? Prior research points to two formal institutions: strength of property rights (e.g., Mauro, 1995; Svensson, 1998; Claessens and Laeven, 2003) and access to external financing (e.g., Levine, 1997; Rajan and Zingales, 1998; Levine, Loayza, and Beck, 2000). Country-level data cannot shed light on which of these institutions is more important for economic growth because they are highly correlated. Recent research therefore relies on micro data to disentangle the effects of property rights and external finance, examining their relative importance in explaining firms' profit reinvestment decisions. Johnson, McMillan, and Woodruff (2002), for instance, demonstrate that weak property rights are the central impediment to profit reinvestment in five postcommunist countries (Poland, Slovakia, Romania, Russia, and Ukraine). In contrast, Cull and Xu (2005) find for a sample of firms from China that access to external financing is an equally important predictor of profit reinvestment, suggesting that the importance of market-supporting (financial) institutions depends on the level of development of a country's economy (McMillan and Woodruff, 2002). (1) Extending the above line of research, in this paper, we examine the relation between an important informal institution--national culture--and profit reinvestment by small firms in emerging markets and we investigate whether culture affects the relative importance of formal institutions for profit reinvestment decisions.

We are interested in the role of national culture for economic growth in emerging economies for two reasons. First, in such economies where formal institutions are weaker, informal institutions such as national culture should matter more. Hence, we should be more likely to observe a direct effect of informal institutions, as opposed to an indirect effect through formal institutions. Hofstede (2001) shows that national culture and economic development are correlated. However, the literature has yet to identify a clear channel through which informal institutions affect the economy. A direct association between culture and profit reinvestment may provide one answer. Second, because culture is located at the most basic level in a stratified system of institutions (Williamson, 2000), and formal institutions must be compatible with culture in order to be effective (Licht, Goldschmidt, and Schwartz, 2005), the effectiveness of efforts to increase the level of economic development (e.g., by facilitating profit reinvestment) is likely to depend on a country's cultural profile.

To proxy for culture, we focus on two cultural dimensions from Schwartz's (1994) widely accepted framework: Embeddedness, which captures cultural emphasis on conformity and the status quo, and Hierarchy, which captures cultural acceptance of an unequal distribution of power. These dimensions may affect reinvestment indirectly, through their correlations with formal institutions such as economic development, political rights, and economic freedom (Schwartz, 2006), or directly, through their effect on the motivation to invest. To the extent that our sample focuses on emerging markets with similarly weak formal institutions and a large number of small firms for which investment policies are largely determined by managers' individual investment motivations, culture is more likely to exert a direct effect than an indirect effect on reinvestment. …

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