Equity market liberalizations open domestic stock markets to foreign investors. A puzzle in the literature is why developing countries exhibit relatively small financial impacts associated with liberalizations. We use cross-firm variation in corporate governance at the time of official equity market liberalization in Korea to test whether governance can explain the extent to which firms benefit when countries liberalize. The results show that better-governed firms experience significantly greater stock price increases at the equity market liberalization. Following the liberalization in Korea, foreign ownership in firms with better corporate governance was significantly higher than that in firms with poor governance. Better-governed firms also exhibit higher rates of physical capital accumulation in the period after liberalization.
Keywords: equity market liberalization, risk sharing, cost of capital, corporate governance
JEL classification: D23, G21, G32, K42
Introduction
Stock market liberalization is a decision by a country's government to allow foreign investors to purchase shares in companies listed on the domestic market. Theory predicts that when a country liberalizes, foreign capital will surge into that country since rates of return to capital are much higher in developing economies than they are in the rest of the world. The impact of liberalization works through a reduction in the cost of capital - real interest rates decline and systematic risk falls as the relevant benchmark for pricing risk changes from the local market index to a world market index. Consequently, firms in liberalizing countries should experience stock price revaluations and their rate of capital accumulation should rise until their marginal product of capital is driven down to the new lower cost of capital.
While existing studies provide some support for both of these predictions, a continuing puzzle in the literature is that the financial impact of liberalization is not as large as that predicted by theory. Lucas (1990) shows that neoclassical models of trade and growth predict much larger capital flows into developing countries than what is observed in reality. A prominent explanation for this paradox is that foreign investors face a greater risk of expropriation, which leads to low equity flows into these countries (Henry and Lorentzen 2003, Stulz 2005). Foreign investors are at an informational disadvantage relative to local investors and incur higher monitoring costs when they make investments in firms with questionable corporate governance.
The question is to what extent poor corporate governance explains the relatively small impact of equity market liberalization. If corporate governance drives foreign investor interest in the stocks of a country, then we should expect firms with better corporate governance to experience higher stock price revaluations at the time of liberalization. Furthermore, better-governed firms should exhibit higher rates of capital accumulation.
We test these predictions using disaggregated data from Korea. The Korean stock market is ideal for this experiment since Korea is perhaps the only emerging market economy where it is possible to obtain ownership and governance data from the late 1980s and early 1990s, a period during which many emerging markets liberalized their stock markets (Korea officially liberalized its equity market in January 1992). The ability to exploit within-country variation in corporate governance provides more powerful tests of the impact of governance on stock price revaluations and investment growth than is possible from country-level studies. The data allow us to construct three measures of corporate governance. Our first measure is the ownership by the largest shareholder. We expect governance problems to be less severe in firms in which the largest shareholder has greater ownership of cash-flow rights. Second, we use affiliation with business groups known as chaebols. The business and ownership structures in chaebols provide controlling shareholders an ability to expropriate outside investors and incentives to do so. Third, we use an indicator for dividend-paying firms since we expect these firms to be better governed than non-dividend paying firms.
We present three key findings. First, the abnormal returns in the liberalization month are significantly higher for firms that have strong governance. All else equal, non-chaebol firms experience abnormal returns that are 10% higher than those for chaebols. Dividend-paying firms experience 9% higher abnormal returns upon liberalization. Similarly, we find that abnormal returns are positively related to ownership by the largest shareholder.
Second, firms in Korea with better corporate governance attracted significantly larger foreign ownership in the aftermath of liberalization than firms with relatively poor governance. The results show that, after controlling for firm characteristics, foreign ownership was significantly higher for non-chaebols, for firms with more concentrated ownership, and for firms that pay dividends.
Third, we find that the investment growth rate is higher for firms for which foreign ownership increases and for independent firms that are not affiliated with business groups. These findings suggest that better-governed firms with greater foreign ownership tend to have higher rates of physical capital accumulation in the period after the liberalization.
Overall, our evidence underscores the importance of governance in explaining within-country cross-firm variation in the benefits of stock market liberalization. Better-governed firms experienced significantly higher stock price revaluations at the time of liberalization, attracted greater foreign ownership, and exhibited higher rates of physical capital accumulation in the period following the liberalization.
The results of this study have significant policy implications. If firms with weak governance structures do not benefit from liberalization, perhaps owing to entrenched controlling shareholders, then policymakers should focus more on improving governance structures before liberalizing their markets. In this examination of the impact of governance structures on the benefits of liberalization within a country, we find that governance matters.
This paper is organized as follows. We discuss testable predictions and describe corporate governance measures in Section 2. Section 3 describes the data and variables. This section also presents descriptive statistics and correlations among variables. Section 4 examines the effect of corporate governance on liberalization returns. In Section 5, we examine foreign ownership after liberalization and how it responds to firm-level governance measures. Section 6 examines the effect of governance on changes in investment rates following liberalization. Section 7 concludes the paper.
Measures of Corporate Governance
2.1 Chaebol affiliation
As noted above, our first measure of corporate governance is a firm's affiliation with a business group, known in Korea as a chaebol. These business groups have governance structures that are highly conducive to expropriation of outside investors as the control in a chaebol is heavily concentrated in one family that makes most of the major decisions for all of the group's member firms. Their boards have few outside directors. The professional managers in these firms own little equity.
The family's ability to control member firms without purchasing significant a direct stake in individual firms is facilitated through extensive interlocking institutional ownership and complex pyramidal ownership structures. The divergence between cash flow and control rights, together with weak incentives of individual and institutional shareholders to monitor controlling shareholders, gives them both the ability to expropriate and the incentives to do so.
The expropriation can take a number of forms, including excessive compensation, transfer of corporate opportunities, share issues that dilute minority investors, and insider trading. A particularly stark example of expropriation is reported by Bae, Kang, and Kim (2002), who study merger transactions by chaebol firms in the 1990s. They show that at the announcement of an acquisition, chaebol bidders experience large wealth losses while other portfolio companies in the group experience large wealth gains. This diversion of resources from firms low on the pyramid to those high on the pyramid is one of many illustrations of expropriation possibilities in chaebols. In another example, Chang (2003) finds that controlling shareholders in chaebols use private information to increase their stake in more profitable firms. Chang also finds that chaebols transfer profits to other affiliates through intra-group trades. The higher expected consumption of private benefits lowers the value of chaebols (see, for example, Joh 2003). Further, Baek, Kang, and Park (2004) show that at the onset of the Asian financial crisis of 1997, chaebol stocks suffered a much larger decline in value than other firms, supporting the view that controlling shareholders have a greater incentive to expropriate wealth from minority shareholders during crisis periods. While governance in Korea has improved since the Asian financial crisis, the period that we focus on, the early 1990s, was one in which minority investors faced larger expropriation risks in chaebols than investors in non-chaebols ("independent firms"). Firms affiliated with chaebols are identified from announcements, made annually by the Korea Fair Trade Commission, of member firms in the top 30 chaebols.
2.2 Largest shareholder ownership
Our second governance variable focuses on ownership rights of the largest shareholder. In most cases, the largest shareholder is the founder, a controlling shareholder, or a family involved in the management of the firm. According to Joh (2003), in approximately 80% of Korean firms, the largest and controlling shareholder is among the top executives. In the other 20%, the largest shareholder is a state-controlled enterprise or a financial institution.
Greater ownership by the largest shareholder mitigates the adverse impact of agency problems and information asymmetries. If controlling insiders own small stakes, their incentives to extract large private benefits are greater. However, if these insiders own large stakes, then their expropriation of corporate wealth would be at their own expense since it would reduce the value of their stake. In other words, the more shares the largest shareholder owns, the higher the cost of expropriation.
The evidence for both Korea and other emerging markets consistently shows that firm valuation is positively related to ownership concentration. For example, both Mitton (2002) and Joh (2003) find that firm profitability is higher when the controlling shareholders own large stakes. Claessens, et al. (2002) find that firm value increases with the ownership of the largest shareholder. Other studies based on data from emerging markets also support the view that greater ownership of cash flow rights by the largest shareholder aligns the interests of controlling shareholders with those of minority shareholders.
2.3 Dividend-paying dummy
The third measure of the quality of governance is whether a firm pays a dividend. It is commonly argued that dividend payments could mitigate agency problems between corporate insiders and outside investors (Easterbrook 1984, Jensen 1986, Fluck 1998, Myers 2000). Dividends play a basic role in limiting insider expropriation because they remove corporate wealth from insider control (Faccio et al. 2001, La Porta et al. 2000). In addition, dividend-paying firms commit themselves to greater monitoring by external capital markets because they are more likely to access external capital markets to meet funding needs (Easterbrook 1984, Jensen 1986).
The existing evidence is consistent with the argument that dividend-paying firms exhibit relatively better governance. Using a cross section of 4,000 firms from 33 countries, La Porta et al. (2000) show that stronger minority shareholder rights are associated with higher dividend payouts. Similarly, Faccio, Lang, and Young (2001) show that group-affiliated corporations in Europe pay higher dividends than those in Asia, dampening insider expropriation.
2.4 Expropriation risks and foreign investor holdings
In efficient markets, higher expropriation risk simply lowers firm value. As long as the expropriation is exogenous and the discount due to expropriation risk is reflected in firm value, the anticipated expropriation should have no impact on investment decisions by portfolio investors. However, portfolio decisions will be affected if local and foreign investors face different information and monitoring costs.
Existing studies show that local investors have a comparative information advantage over foreign investors. Kho, Stulz, and Warnock (2009) and Leuz, Lins, and Warnock (2009) argue that local investors benefit from their proximity to local firms. Proximity gives local investors more precise information about the consumption of private benefits and expropriation risks inherent in decisions made by insider-controlled firms. Proximity also lowers monitoring costs for local investors since they can better influence controlling shareholders through their social networks. Likewise, foreigners are at a disadvantage to local investors when evaluating transactions within group companies. The higher costs for foreign investors manifest themselves in lower holdings of stocks of poorly governed firms.
Thus, if foreign investors stay away from poorly governed firms after liberalization, then these firms will experience relatively small capital inflows and the financial impact of liberalization will be relatively weak in these firms. We predict better-governed firms, such as non-chaebol firms, firms with concentrated ownership, and dividend-paying firms, will experience larger stock price revaluations and exhibit greater increases in capital investment rates.
Data
The accounting and ownership data for publicly traded Korean firms are from the Listed Company Database of the Korean Listed Companies Association. We exclude regulated firms. We also exclude thinly traded stocks by requiring continuous availability of monthly returns during the five-year period 1988-1992. We impose this restriction to ensure that we have reliable estimates of systematic risk for the sample firms. In addition, we exclude firms with missing ownership and key financial variables. These exclusions result in a final sample of 314 firms. Local currency values are converted to real values using the CPI deflator. The CPI index data are from ECONSTATS Global Data (the data are maintained by the International Monetary Fund and can be downloaded from http://www.econstats.com).
3.2 Identifying the stock market liberalization date for Korea
A critical question is when the market first learns of a credible impending liberalization. Explicit barriers to investing in the Korean equity market fell in January 1992, when a formal regulatory change officially allowed foreign investors to invest in Korean equities. The official liberalization meant that foreign investors could own up to 10% of the capitalization of a company, while no individual foreign investor could own more than 3% (see Bekaert and Harvey 2005). We use the official liberalization date of January 1992, following a number of previous studies that use this date as the liberalization date for Korea (see, for example, Kim and Singal 2000, Chari and Henry 2004, and Bekaert, Harvey, and Lundblad 2005).
An earlier date, June 1987, is used by Henry (2000a) and Chari and Henry (2008), who prefer the date of establishment of a country fund as the liberalization date. However, the reason for the choice of June 1987 is unclear because Korea began allowing limited access to its stock market through a closed-end fund as far back as 1984. The first country fund permitting foreign ownership, the Korea Fund, was listed on the New York Stock Exchange (NYSE) in August 1984. Country funds are typically small (the Korea Fund was $60 million at the time it was listed). Thus, establishing a country fund does not result in a large capital inflow into emerging markets.
To resolve the dating question, Bekaert, Harvey, and Lumsdaine (2002) use structural break tests to date the capital market integration. Their tests show that the Korean market integrated with the rest of the world in January 1992 (the Wald statistic for that month is above its critical value).
3.3 Descriptive statistics
Table 1 reports descriptive statistics for the key variables. The average market capitalization at the end of 1991 was US$86.1 million (using an exchange rate of 1,000 won per US$1). However, the median market capitalization was about $28 million; the positive skewness suggests that the sample contains a small number of relatively large firms. The leverage ratios of Korean firms appear to be surprisingly high - the average debt-to-book assets ratio was 0.75 and the median was 0.73. These numbers are significantly larger than those in other countries, but they seem typical for firms in Korea. Joh (2003), for example, reports debt-to-equity ratios of between 300 and 400% for Korean firms in her sample during the early 1990s. A debt-to-equity ratio of 300% is consistent with a debt-to-book capitalization ratio of 75%. Korean firms do not appear to have been very profitable. The operating cash flow (net income plus depreciation) to-total-assets ratio averaged to about 3.6% (the median is 3.0%).
We also report summary statistics on differences in systematic risk from switching the benchmark index from a local market index to a world market index. Liberalizing a country's stock market changes the relevant source of systematic risk for pricing a firm's shares from a local market index to a world market index. The local market beta is the beta estimate from the market model regression of monthly stock returns for each firm during the three-year period 1988-1990 on the Korean Composite Index (KOSPI), a value-weighted stock index of all listed Korean stocks. The world market beta is similarly estimated from a regression of firm returns on DataStream's MSCI world market portfolio returns ("the world market index return") for the period 1988 through 1990. The average local market beta was 0.784. The average world market beta is 0.615 - significantly lower than the local market beta. The Diff_beta, which is the difference between the local market beta and the world market beta, averages to about 0.169. This reduction in the average firm beta from switching the relevant market for pricing the asset risk is both statistically and economically significant.
The summary statistics on the three governance variables show that roughly 29% of the sample firms are affiliated with chaebols. The largest shareholder owned an average of 23% of the stock in the firms, and about 79% of the firms paid dividends.
Theory predicts that liberalizations reduce the cost of capital and that the effect should show up in stock price revaluations at the time of liberalization. Consistent with the predictions of the theory, Henry (2000a), Kim and Singal (2000), and Chari and Henry (2004) report significant stock price revaluations associated with liberalizations. We follow the literature to estimate abnormal returns in the month of liberalization with standard event study methods (following Brown and Warner 1985). The abnormal returns are estimated for two different windows - month [0] and months [-1, 0], where month 0 is the event month or the month of liberalization. The parameters for the market model are estimated using monthly returns over the [-48, -13] interval. As a robustness check, we also estimate abnormal returns using a mean-adjusted return model and find qualitatively identical results. To save space, these results are not reported.
The average abnormal return in the liberalization month (AbRet0) is 16.2%, with a standard deviation of 21.4%. The median is 13.6%. The cumulative abnormal returns over the two-month window (the liberalization month and the month before), CAR-1,0, are also economically large (the mean is 14.0% and the median is 12.8%). Overall, the evidence shows large positive stock price revaluations of Korean firms at the time of liberalization.
3.4 Correlations
Table 2 reports the estimated correlations between liberalization-month abnormal returns, firm characteristics, and governance measures. The correlations between abnormal returns and governance variables are consistent with the view that better-governed firms experience larger financial impacts. The estimated correlation coefficient between liberalization-month abnormal returns and the chaebol-affiliated firm dummy is -0.291. Likewise, the correlation between abnormal returns and the largest shareholder ownership is 0.235 and that between abnormal returns and the dividend-paying dummy is 0.239. All of these correlations are significant at the 1% level.
The table further shows that abnormal returns in the liberalization month are negatively correlated with both firm size and firm leverage and positively correlated with firm profitability. According to Chari and Henry (2004), liberalization-induced reductions in systematic risk should result in greater stock price revaluations. To examine this view, we estimate the correlation between Diff_beta and liberalization-related stock price revaluations. We find almost no correlation between abnormal returns and Diff_beta.
The correlation between the chaebol-affiliated firm dummy and largest shareholder ownership is significantly negative, which supports our earlier discussion about the ability of chaebol owner-managers to maintain control over affiliated firms with relatively small shareholdings. As described earlier, chaebols make this possible through extensive shareholding agreements among member firms.
In addition, the correlation between chaebol affiliation and the dividend-paying dummy is significantly negative. The lower propensity to pay dividends by chaebols compounds the governance problems since fewer dividend payments imply that chaebols have access to larger resources, which are potentially subject to expropriation.
Liberalization Returns and Corporate Governance
The extent to which removing restrictions on capital flows affects domestic firms depends on the interest that foreign investors have in stocks in that country. As argued earlier, the interest of foreign investors depends on corporate governance. Few foreigners would be interested in stocks of firms where the incentives to expropriate outside investors are large. A direct empirical prediction is that stock price revaluations associated with market liberalization would be greater for firms that provide greater protection of minority rights. In other words, firms that we identify as better governed - such as non-chaebol firms, firms with concentrated ownership, and dividend-paying firms - should experience larger stock price revaluations than other firms. Section 4.1 presents univariate tests that compare abnormal returns in the month of liberalization for poorly and better-governed firms. Section 4.2 provides multivariate tests that examine abnormal returns as a function of the governance variables.
4.1. Univariate tests
Table 3, Panel A reports the mean and median liberalization return for firms affiliated with chaebols and for firms that are unaffiliated. As expected, we find that independent firms (firms not affiliated with chaebols) exhibit significantly larger stock price revaluations in the month of liberalization than firms that are affiliated with chaebols. The mean and median abnormal returns for non-chaebol firms are about 20%. By contrast, the mean and median abnormal returns for chaebol-affiliated firms are only about 7% and 3%, respectively. The differences in the mean and median returns between chaebol and non-chaebol firms are statistically significant at the 1% level.
Panel B partitions the sample by the median equity ownership of the largest shareholder. We find significantly higher abnormal returns for firms with high equity ownership by the largest shareholder. In such firms, the mean abnormal return is 22% and the median is 20%. By contrast, in firms with low equity ownership by the largest shareholder, the mean and median abnormal return are only 10.4% and 7.6%, respectively. The tests of differences in means and medians show that abnormal returns are significantly different across two sub-samples. The stock price revaluations are much higher for firms in which the largest shareholder owns a bigger stake.
Panel C reports the mean and median abnormal returns for firms that pay dividends and for those that do not. The mean abnormal return for firms that pay dividends is 18.8%. By contrast, the mean abnormal return is only 6.4% for firms that do not pay dividends (the t-test for equality of means is rejected at a p-value of 0.00) The medians for the two sub-samples similarly differ from each other - the dividend-paying firms have a median abnormal return of 17.7% while the non-dividend-paying firms have a median of only 4.7%.
Overall, the significantly higher abnormal returns for firms that score high on governance suggest that the financial impacts of liberalization are much larger for firms that provide better protection to outside investors.
4.2. Cross-sectional analyses
Table 4 presents results from regressions that relate stock price revaluations to governance variables, changes in foreign ownership, differences in betas, and other firm characteristics. The key question that is addressed in these tests is whether better-governed firms experience a relatively larger fall in the cost of capital and consequently a larger stock price revaluation in response to liberalization. In addition, we examine whether changes in future foreign ownership drive abnormal returns at the time of liberalization. Abnormal returns will be higher for stocks that have a greater likelihood of being bought by foreign investors. We record actual changes in foreign ownership between the time of liberalization and three years following liberalization and create an indicator variable that takes a value of one if foreign ownership in the stock increased over this three-year period, and zero otherwise.
Further, we test whether opportunities for risk diversification drive the stock price revaluations that accompany stock market liberalization. The risk-sharing view implies that the greater the difference between the historical beta of the firm's stock returns relative to the local market and the historical beta of the firm's stock returns relative to the world market (Diff_beta), the larger the expected drop in the cost of capital and the higher the unexpected stock price response to the news of liberalization. However, risk-sharing will have a larger impact on the unexpected stock price change if firms are investible - i.e., eligible for foreign ownership at the time of liberalization (Chari and Henry 2004). Thus, stock price revaluation of the investible firms should be more strongly related to Diff_beta. We therefore construct an indicator variable, INVEST, that takes a value of one for firms that reported non-zero foreign ownership at the time of liberalization, and a value of zero otherwise. Firms in which foreigners own stock at the time of official liberalization are more investible than firms with no foreign ownership. To test whether risk-sharing has a larger financial impact on investible stocks, the regressions include an interaction term between INVEST and Diff_beta.
Panel A of Table 4 reports results from regressions where the dependent variable is the month [0] of abnormal returns associated with equity market liberalization in Korea. We begin by estimating a benchmark regression that tests the risk-sharing view (in column 1) and then add the governance variables to this specification (in columns 2 to 6). The benchmark regression specification includes firm size, leverage, cash flow, increases in future foreign ownership dummy, Diff_beta, INVEST, and the interaction term Diff_beta Ã- INVEST.
The results in column 1 of Table 4 show a negative and significant coefficient on the log of market capitalization. Two potential explanations exist for why the financial impacts of liberalization are larger for smaller firms. First, small firms are relatively more capital constrained. Consequently, capital flows following liberalization have a much larger impact on the rates of return to capital in small firms than in large firms. A second possibility is that smaller firms experience larger productivity shocks than large firms in the aftermath of liberalization. The other firm characteristic that matters in explaining the cross-section of abnormal returns is firm profitability. The strong positive relation between abnormal returns and firm profitability is consistent with the idea that foreign investors prefer profitable firms.
Foreign ownership changes in the next three years are positively related to abnormal returns. The abnormal returns are almost 6% higher for firms that experience an increase in foreign ownership in the three years following liberalization than for those that exhibit no change in foreign ownership.
We find some weak evidence supporting the risk-sharing view for firms that are investible. The coefficient on Diff_beta gives the effect of risk-sharing conditional on there being no foreign ownership in the month of liberalization. The estimate is insignificant, suggesting that risk-sharing does not explain the repricing of firms with no foreign ownership at the time of liberalization. However, the coefficient estimate on the interaction of the INVEST dummy with Diff_beta is positive and marginally significant in some of the specifications. The sum of the coefficients on Diff_beta and Diff_beta Ã- INVEST (which adds up to 0.127) gives the total effect of risk-sharing on stock price revaluations for firms with foreign ownership. Given the average Diff_beta of 0.160, the estimate suggests that the average firm with positive foreign ownership at the time of liberalization could expect a stock price revaluation of 2.03% (0.160Ã-0.127).
Our key results are those that relate governance variables to stock price revaluations associated with stock market liberalization. Column 2 augments the benchmark regression by including the chaebol-affiliation dummy as an additional explanatory variable. We find a negative and significant coefficient on the chaebol-affiliation dummy supporting our argument that poorly governed firms benefit less from equity market liberalization. The estimate suggests that firms affiliated with business groups realize a repricing of their stocks that is 10.2% lower than do firms that are not affiliated with business groups.
In column 3 of Table 4, we replace the chaebol dummy with equity ownership by the largest shareholder. As expected, abnormal returns are positively associated with equity ownership by the largest shareholder. The coefficient estimate of 0.289 is both statistically significant and economically important.
Column 4 of Table 4 examines the effect of dividend-paying status on abnormal returns. The dividend-paying dummy equals one if the firm paid a dividend in the year before liberalization, and it is zero otherwise. The coefficient estimate is positive and highly significant. Dividend-paying firms realize 9.4% higher revaluation in the liberalization month than non-dividend-paying firms.
Column 5 of Table 4 includes all three governance variables as explanatory variables and examines the total effect of governance. We find that all three governance variables are significant. Non-chaebol firms, dividend-paying firms, and firms with high equity ownership by the largest shareholder realize greater revaluation benefits. Note the large increase in adjusted R2 (from 0.19 in column 1 to 0.26 in column 5), suggesting that each of the three governance variables captures a different aspect of a firm's governance structure.
We now examine whether the relation between stock price revaluation and Diff_beta is conditional on the strength of a firm's governance. Diff_beta lowers the cost of capital only when foreign investors invest in stocks after the opening up of local stock markets. If foreign investors prefer stocks of firms with good governance, then better-governed firms should experience revaluations that are more strongly related to Diff_beta. To test this idea, in column 6 of Table 4 we include interaction terms between Diff_beta and the three governance variables. The only interaction that is significant is that between Diff_beta and concentrated ownership. The estimated coefficient on the interaction term between Diff_beta and ownership by the largest shareholder is positive and statistically significant. We have also examined these interactions one at a time, and the results are similar to those reported in column 6.
Panel B of Table 4 presents the estimates for the month [-1, 0] window. The results are similar to those reported in Panel A, with two exceptions. First, the coefficient estimates on INVEST are significantly positive, suggesting that stock price revaluations were larger for firms that had some foreign ownership at the time of liberalization. Second, we find, interestingly, that the risk-sharing effect on the revaluation of investible stocks is stronger as the interaction term between Diff_beta and INVEST is positive and statistically significant in most of the specifications. The estimates suggest that investible firms can expect a stock price revaluation of 4.8% (0.282 Ã- 0.169) during the [-1, 0] period relative to the liberalization month.
In unreported tables, we tested robustness to our choice of return model in calculating abnormal returns. More specifically, we replicated all of our tests using mean-adjusted abnormal returns instead of market-model residuals. The results are qualitatively identical.
Foreign Ownership and Corporate Governance
The key premise of our tests is that foreign investors prefer investing in shares of better-governed firms. A more direct way to address this issue is to examine whether corporate governance variables affect the variation in foreign ownership of Korean firms in the period immediately following the liberalization. If governance has any effect, then we expect relatively lower foreign investment in shares of chaebol-affiliated firms and relatively more ownership by foreigners in firms with concentrated ownership and in firms that pay dividends.
Before presenting formal tests, we present a time-series plot of average foreign ownership during the period 1987-1997 in Figure 1. During the pre-liberalization period of 1987-1991, foreigners owned only a few stocks (through country funds). The average fraction of shares owned by foreigners during this period was about 2%. Following liberalization, foreign ownership jumped to 3.79% in 1992 and continued to increase in the subsequent two years to 5.17% in 1993 and to 5.95% in 1994. The average foreign ownership declined slightly after 1994.
In Table 5, we report results from panel regressions of foreign ownership on governance variables. The sample period is 1992-1994. The key explanatory variables are the three corporate governance variables - the chaebol-affiliated firm dummy, ownership by the largest shareholder, and the dividend-paying dummy. The regressions control for lagged values of firm size, leverage, and profitability since previous studies show that foreign investors display a preference for large, less leveraged, and more profitable firms (Kang and Stulz 1997, Dahlquist and Robertsson 2001, Aggarwal, Klapper, and Wysocki 2005, Leuz, Lins, and Warnock 2009, Covrig, Lau, and Ng 2006, Ferreira and Matos 2008). Since foreign ownership is highly persistent, we also include lagged foreign ownership in the regressions.
The coefficient estimates on control variables are consistent with the previous literature. Foreign ownership is high in firms that are large and more profitable. Leverage is unrelated to foreign ownership. Lagged foreign ownership has a positive and statistically significant coefficient, suggesting a high degree of persistence in ownership.
Column 1 shows that the estimated coefficient on the chaebol-affiliation dummy is negative and statistically significant. All else equal, ownership of foreign investors in chaebol-affiliated firms is lower by 1.3% than that in non-chaebol-affiliated firms. With an average foreign ownership of 4.97% during 1992-1994, a decrease of 1.3% represents a 26% decline from the average.
In column 2 we include ownership by the largest shareholder in place of chaebol affiliation. We expect foreign ownership to be higher in firms with concentrated ownership because these firms are expected to have fewer governance problems. A caveat is that ownership structure affects float because firms with higher ownership by the largest shareholder have fewer shares available for purchase by foreigners. This imparts a negative bias to the relation between foreign ownership and ownership by the largest shareholder. Despite the bias, we find that the coefficient on ownership by the largest shareholder is positive (significant at the 10% level). The results show that, all else equal, foreign investors prefer to own more stock in firms in which ownership is more concentrated.
In column 3 of Table 5 we test whether foreign ownership is higher in dividend-paying firms. Consistent with our prediction, we find that foreign investors own 1.1% more stock in dividend-paying firms than in non-dividend-paying firms, all else equal. Column 4 considers all three governance variables together. The chaebol-affiliation dummy is still negatively related to foreign ownership. Similarly, the dividend-paying dummy continues to be positively related to foreign ownership. However, ownership by the largest shareholder loses significance. Overall, the findings suggest that foreign ownership was significantly higher in larger, more profitable, and better-governed firms following the liberalization of the equity markets in Korea.
6. Growth Rate of Capital Stock
Theory predicts that, as the cost of capital falls, firms will respond by increasing their rate of investment until the marginal product of capital is driven down to the new cost of capital. This implies that the liberalization-induced investment response will be negatively related to the change in the cost of capital; firms with larger declines in the cost of capital will increase their investment rates while those with a smaller decline (or an increase) in their cost of capital will have a more muted investment response to liberalization.
Our evidence thus far shows that foreign investors prefer better-governed firms and that these firms exhibit a much larger stock price revaluation in response to news of liberalization. A larger liberalization-induced increase in Tobin's q for better-governed firms implies that the optimal response for these firms is to increase their investment rates more than poorly governed firms do. We exploit this variation in abnormal capital stock growth rates to examine whether firms with better corporate governance have higher rates of physical capital accumulation, as theory predicts. Thus, we expect non-chaebols, firms with concentrated ownership, and dividend-paying firms to exhibit larger increases in investment rates.
We define the investment growth rate of each firm's capital stock, as the growth rate of its capital stock in year t minus the average pre-liberalization growth rate of the firm's capital stock. Following Chari and Henry (2008), we predict that the pre-liberalization mean of the growth rate of capital stock is a reasonable forecast of the firm's expected future growth rate. The investment growth rate of each firm's capital stock is estimated as follows. First, we take the natural log of nominal net fixed assets at time t and subtract from it the natural log of net fixed assets at time t-1. Second, we take the natural log of the consumer price index (CPI) at time t and subtract the natural log of the CPI at time t-1. Third, we obtain the real growth rate of each firm's capital stock between year t-1 and t by subtracting the inflation growth rate from the nominal fixed-asset growth rate. In the end, we compute the deviation of capital stock growth from the pre-liberalization average growth rate as the growth rate of firm i's capital stock in year t minus the average growth rate of firm i's capital in the five-year period preceding liberalization. The abnormal growth of their capital stock provides a measure of the investment response of firms to the event of liberalization.
The average deviation during the three years following liberalization is -3.3%. The decline in investment growth rates contradicts the standard prediction of a positive investment response to liberalization. The decline is attributable to macroeconomic changes that affected the entire Korean economy. The previous five-year period 1987-1991 was a period in which the Korean economy experienced spectacular economic growth. This period witnessed an average annual GDP growth rate of about 9%. The GDP growth declined following this unusual growth in the period 1987-1991. This decline coincided with the liberalization. We therefore do not make any time-series predictions on within-firm changes in growth rates. Instead, we exploit the cross-sectional variation in growth rates. Although macroeconomic factors affect all firms in the economy, we do not expect them to affect better-governed firms differently than they do poorly governed firms. We checked and found that the industry distribution of better-governed firms is no different from that of poorly governed firms. Therefore, it should still be the case that better-governed firms have higher investment rates than poorly governed firms.
The regressions reported in Table 6 relate abnormal growth rate of capital stock in the aftermath of liberalization to changes in foreign ownership, measures of governance, and firm characteristics that are expected to affect the investment responses of firms. The governance variables and firm characteristics are lagged by one period to ensure that they are in the information set of managers. All of the regressions include year indicator variables. The standard errors are clustered at the firm level.
We include three firm characteristics: firm size (the natural log of market capitalization), leverage, and the cash flow-to-assets ratio. Because larger firms attract greater foreign ownership, their optimal response is to invest more. Leveraged firms are relatively more constrained, and therefore liberalization will result in a larger change in the investment rates of firms with more debt. The predictions on how the cash flow-to-assets ratio affects the rate of capital accumulation are ambiguous because firms that are more profitable attract more foreign ownership but are also less constrained.
Column 1 of Table 6 presents results from regressions of abnormal growth of capital stock on just the firm characteristics. The results show no effect of firm size and cash flows on investment growth. Leverage positively affects investment growth. We expect firms with larger increases in foreign ownership to experience a larger drop in their cost of capital and consequently a larger increase in investments. We therefore augment the benchmark regression to include changes in foreign ownership. The results in column 2 show that changes in foreign ownership are positively and significantly related to changes in investment growth rates following liberalization. The magnitude of the estimate is also economically significant. A one-standard-deviation increase in the variable, holding other variables constant at their means, is associated with an increase of 2.8% in the growth rate of capital stocks. The positive coefficient on changes in foreign ownership suggests that larger investments by foreigners generate larger investment responses from firms when a regime shifts allows foreigners to purchase shares of domestic firms.
Columns 3 to 5 of Table 6 examine the effects of governance variables on investment growth rates. Because chaebol-affiliated firms are poorly governed and experience lower stock price revaluations, we expect these firms to exhibit smaller growth in investment than non-chaebol firms. The negative and statistically significant coefficient on chaebol affiliation in column 3 supports the prediction that poorly governed firms exhibit a more muted investment response to liberalization.
Columns 4 and 5 of Table 6 similarly show that investment responses to liberalization are positively related to the quality of governance. Firms with concentrated shareholder ownership show relatively higher growth rates of capital stock, although the coefficient estimate lacks statistical significance. Similarly, column 5 shows that firms paying dividends increased their investments faster after liberalization. The coefficient estimate suggests that firms that pay dividends realized growth rates of physical stocks that were 4.7% higher than those of firms that did not pay dividends. Column 6 includes all three governance variables together. The only governance variable that has a robust effect on the growth rates of capital stocks is the chaebol affiliation. Firms that are affiliated with business groups realize abnormal growth rates of capital stocks in the period following liberalization that were 8% lower than those of independent firms.
In an efficient market, a firm's post-liberalization investment decisions should reflect signals about fundamentals that are embedded in stock price changes that occur at liberalization. Are changes in investment correlated with changes in stock prices? Consistent with this idea, Chari and Henry (2008) find that the growth rates of capital stocks during the post-liberalization period are positively related to stock price changes during the liberalization year. The results in column 7 of Table 6 confirm that investment responds to signals embedded in stock price revaluations at the time of liberalization. The coefficient estimate on liberalization returns is 0.09 and is statistically significant at the 1% level.
Overall, the results indicate that investment growth during the post-liberalization period is much larger for firms that are better governed and for firms in which foreign investors take larger equity stakes.
Conclusions
The economic benefits of equity market liberalization have not been as large as theory predicts. A question that has been of considerable interest to researchers is whether poor investor protection in emerging markets hinders equity flows into liberalizing economies. Foreign investors often claim that they avoid investing in stocks of poorly governed firms because of the risks of expropriation.
In this paper, we examine the extent to which corporate governance affects cross-firm variations in the financial impacts of liberalization. We expected better-governed firms to exhibit higher stock price revaluations at the announcement of liberalization. We also expected better-governed firms to exhibit higher rates of physical capital accumulation following liberalization. In tests of these predictions using data surrounding the Korean market liberalization in January 1992 we found strong support for our predictions.
The results show that independent firms that are not affiliated with business groups, firms with high equity ownership by the largest shareholder, and dividend-paying firms realize greater benefits from stock price revaluation at liberalization. Consistent with the previous literature, we also find some evidence that risk-sharing plays an important role in the repricing of investible but not of non-investible firms. Foreign investors tend to invest more in firms that are better governed after liberalization, and these firms realize higher growth rates of capital stocks relative to the pre-liberalization period.
Our findings highlight the importance of firm-governance in explaining within-country cross-firm variation in the benefits of stock market liberalization. In future work, it would be interesting to see whether our results can be extended to the cross-country context to confirm that firms in countries with better institutions benefit more from financial globalization.
Acknowledgements
We thank Francois Derrien, Linda Huang, Sung Wook Joh, Woochan Kim, Jiro Kondo, Debbie Lucas, Robert McDonald, Angela Ng, Mitchell Petersen, Ahron Rosenfeld, Susanne Trimbath, seminar participants at Ben Gurion University and Northwestern University, and participants at the 2009 CAFM conference, 6th IEFA conference, ISI conference, 2009 FMA conference, and JCF Special Conference on Emerging Markets for their helpful comments. This research is supported by a grant from the Research Grants Council of the Hong Kong Special Administrative Region, China (Project No. HKUST6299/03H).
