Corporate Governance and Financial Globalization
Stulz, Rene M., NBER Reporter
In his recent book, Thomas L. Friedman makes the case that globalization leads to a flat world. (1) By that, he means that it removes obstacles that, in the past, would have prevented firms and individuals from competing with each other across the world. Such competition improves welfare not only by insuring that goods are produced at the lowest cost but also by making sure that consumers get access to new and better goods. Assuredly, the world is not flat yet. Nevertheless, the metaphor is helpful for understanding the forces that shape our world. It is even more apt to describe the financial world than the world of trade in goods. For many countries, the most significant explicit barriers to trade in financial assets have been knocked down.
In a paper with Andrew Karolyi, I describe how the financial world would look if it were flat. (2) The most striking counter-factual is that, despite the removal of barriers to trade in financial assets, capital does not flow to countries with low-capital stocks as strongly as one would expect. (3) As Robert Lucas once pointed out forcefully, differences in the marginal product of capital between industrialized countries and emerging countries are large. In fact, over the recent past, capital has come rushing into the United States, when one would expect it instead to flow to emerging countries. Using data from the IMF, the cumulative sum of net equity flows to less developed countries from 1996 to 2004 is a negative $67.4 billion.
What then are the obstacles left that make the financial world full of ridges and mountains, so that capital does not flow where the physical marginal product of capital is highest? The answer is that poor corporate governance stands in the way of countries getting the full benefit of financial globalization. With poor governance, firms are valued less by the capital markets, so that entrepreneurs are more limited in their abilities to raise money to finance their activities. As a result, firms are smaller and growth is stymied.
An investment of $100 might be more productive in Indonesia than in the United States, but the investment will not take place in Indonesia if investors expect to receive a higher return on their investment in the United States. Poor governance prevents investors from receiving the full return on their investment, because third parties pick off the fruits of those investments before they are received. For instance, controlling shareholders in a company in Indonesia might siphon off earnings for their own profit rather than using them to provide a return to outside investors.
As I emphasized in a paper with Craig Doidge and Karolyi, corporate governance has two dimensions. (4) First, it has an external, country-level, dimension. The institutions of the country in which a firm is located affect how investors receive a return from investing in the firm. Perhaps most importantly, a country's laws specify the rights that investors have, and the enforcement of the laws determines the extent to which these rights are meaningful. Second, corporate governance has an internal, firm-level, dimension. Firms can organize themselves so that they are well governed. For instance, they can commit themselves to good disclosure, which makes it harder for corporate insiders to take advantage of other investors. The quality of a firm's governance depends both on the quality of internal, firm-level and external, country-level, governance. There has been considerable research on these two dimensions of governance in recent years. In the following paragraphs, I discuss some of the contributions I have made with my co-authors in examining the interaction between financial globalization and corporate governance.
Lee Pinkowitz, Craig Williamson, and I provide a useful way to understand the importance of the governance problem as an obstacle to financial globalization. (5) One would expect, if governance works well, that a dollar of cash would be worth a dollar when the capital markets value a corporation. …