Which of the BRIC economies has the corporate-governance system that is most likely to encourage foreign investment?
Corporate governance, since the 1998 Asian financial crisis, has recently become a mainstream and scholarly concern with relation to the importance of the economic development and well-being of emerging economies. It is generally regarded by academics that corporate governance concerns itself with the behaviour of corporations in terms of their performance, financial and ownership structure and the treatment of shareholders and stakeholders (Claessens & Yurtoglu, 2013). On a broader level, further concerns relate to the way firms are controlled by legal systems and financial markets within these economies. Well-functioning corporate governance mechanisms such as protection and enforcement of minority shareholders’ rights, dispersed concentration of ownership and transparency and disclosure are crucial for local firms and for the attraction of foreign investors (Okpara & Wynn, 2011). Ineffective corporate governance can scare away both domestic and foreign investors and can be disadvantageous towards the economic growth of a country. The main focus of this essay is to establish which of the BRIC emerging economies (Brazil, Russia, India and China), has the corporate governance structure that is most likely to attract foreign investment. This essay will argue that Brazil has the most effective corporate governance system necessary for attracting FDI, supported by the creation of the Novo Mercado which encourages companies to raise their levels of corporate governance in order to list on it.
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It has been observed by Claessens & Yurtoglu (2013) that the nature of corporate governance effectiveness is determined by a countries’ institutional development and degree of legal and judicial efficiency, with Globerman & Shapiro (2003) emphasising that a favourable institutional environment creates beneficial conditions for foreign investment. This includes various interrelated dimensions such as the protection of creditor and shareholder rights and to what extent they are clearly enforced. Similarly, Schleifer & Vishny (1997) argues that legal protection of outside investors limits the extent of their expropriation by insiders, consequently promoting financial development and confidence to foreign investors (Mishra, 2014). Importantly, laws for investor protection may differ among countries due to differences in legal origin, as documented by La Porta et al (1997). He argues that countries with common law origins, one example being India, are generally considered to be better in terms of overall strength of property rights protection, which in turn increases the willingness for investors to provide finance. Conversely, countries with civil law origins that are present in Brazil, China and Russia, are less protective of investors’ rights as a result of the influence of state power and activist governments (Mahoney, 2001) rather than the influence of a common law judge and the rule of the law. Interestingly, Globerman & Shapiro (2003) highlights a disadvantage of La Porta et al (1997) presenting this idea of origin in that it doesn’t conflate the role and efficiency of legal systems with other endogenous factors.
On the other hand however, it is evident that the supervision and enforcement of minority shareholder protection rights remains a significant problem within emerging markets, regardless of their legal origin. The World Bank (2016) report on corporate governance states that most developing and transition economies have failed to enforce laws and regulations on corporate governance evenly and consistently, with the level of enforcement being nearly twice as high in advanced economies. Although the report is subjective to an extent and lacks specific focus on the BRIC economies, evidence of shareholder rights violation and powerful insider control has been debated by (Sprenger, 2000), who gives empirical reference to Russia.
Further reading from Ngwu et al (2017) informs us that the degree to which minority shareholders are protected in emerging economies depends on the firms’ ownership structure. In Anglo-Saxon jurisdictions, such as the US and the UK for example, the ownership structures of corporate governance aim to ensure that managers as agents act in accordance with the interests of their principal owners (shareholders). In comparison, the ownership patterns in the emerging economies differ significantly, with ownership structures experiencing heavy concentration from either dominant managers, families, or the state (Mallin, 2013). In particular, this form of ownership can lead to subsequent conflict between the shareholders (both controlling and minority) and managers, as managers resort to “managerial opportunism” (Aoki & Kim, 1995); making decisions that are in their own interest rather than the shareholders. Millar et al (2005, p.166) further argue that the higher the level of institutional transparency in a country, which they define as “the extent to which there is publicly clear and accurate information covering accepted practices related to capital markets”, then the lower the cost of investing and the better the country’s ability to attract new businesses and external capital. Okpara & Wynn (2011) agree in the sense that higher transparency reduces information symmetry between management and financial stakeholders. Therefore, it is made clear that a combination of dispersing ownership and higher levels of transparency help further protect shareholders and mitigate conflicting agency problems, thus making a country increasingly more attractive to foreign investors.
It is important however not to assume that the corporate governance structures of the BRIC nations are identical, as there are significant dissimilarities. Furthermore, one should need to consider that the corporate governance and regulatory institutions remain in a developmental stage in most of the emerging markets (Clarke, 2015). This next section will analyse the corporate governance of each country in significant detail, beginning with Russia due to the fact that in 2015, the country only attracted US$6.5 billion of FDI, which is significantly less compared to the other three economies compared and much less than the BRIC average of US$93.9 billion (UHY, 2015).
During mass privatisation, which began in 1991, many managers became instant owners and accumulated shares at a nominal cost, thus enriching themselves and diluting the ownership rights of employees and others in the process (Goldman, 1997). Overwhelmingly, this created insider control and not corporate governance by strong outsiders or investors. Although the insider control situation has been slowly eroding, the structure still fails to achieve transparency and accountability towards shareholders, resulting in less structural change and investment but enhancing rent-seeking and paternalism. In an effort at corporate governance reform, the Moscow Exchange established a new premium market segment, Novy Rynok, which focuses at encouraging higher standards of corporate governance and resulting higher valuations (Clarke, 2015). However, Russian law lacks effective definitions of the fiduciary obligation for board directors in the context of broader concerns such as related-party-transactions, enforceability of contractual agreements, and acceptable levels of disclosure (Caron et al, 2012).
As aforementioned, Russia’s legal system stems from civil law origins. With relevance to the opinion of La Porta et al (1997), this may undermine the protection of minority shareholders’ rights and lead to their subsequent expropriation under the influence of state power. Furthermore, Russia ranks 135th /176th on the 2017 Corruption Perceptions Index, (Transparency International, 2017) and 51st/190th in the 2017 Protecting Minority Investors ranking by the World Bank (2017), which highlights that there is room for significant improvement. In addition, the country possesses 56% market capitalisation of stocks as a percentage of GDP (Claessens & Yurtoglu, 2013) and liquidity of stock markets is lower in Russia than in developed markets with similar levels of income (Estrin and Wright, 1999). This means that external investors will find it severely difficult to obtain equity financing. Clarke (2015) presents a cautiously optimistic view on Russia’s innate strengths and huge growth potential, but emphasises that overseas investors are yet to be satisfied with the security of Russia’s investment markets. This makes Russia the country least likely to attract foreign investment out of the BRIC economies.
India is the world’s largest democracy with a variety of political parties and active elections. The country’s legal system also originates from common law. However widely dispersed stock ownership is by no means the norm with shareholdings in India’s largest publicly traded companies remaining highly concentrated between family business groups. Figure 1 shows the extent to which the companies in the country are family owned, with a small figure of only 20% of companies being domestic stand alone. Similarly, only 9% of Indian companies are owned by foreign investors.
Figure 1. Source: (Chakrabarti et al, 2008)
As a result of the severe foreign exchange crisis suffered by India in 1991, the government attempted deregulation and economic liberalisation, setting up various organisations and committee’s with the aim to harmonize India’s corporate governance structure with that of the Anglo-American model. Various organisations that were created include the Securities and Exchanges Board of India (SEBI), set up for regulating the capital markets and replacing inefficient controller of capital issues. The cumulative effect of these committees was to strengthen the rights of shareholders, ensure transparency in financial reporting and correctly establish management responsibilities between the CEO and others. Though on paper the SEBI appears to be a worthy piece of legislation, in reality, unlike the SEC of the US, it has limited power and control over India’s corporations with regards to successful implementation. Estrin & Prevezer (2010) argue that this is a regional issue, with some states having effective legal rights and others, such as Bihar, having an unestablished rule of law.
Much literature regards India’s regulatory framework on corporate governance on paper to be highly impressive, describing it as robust and efficient (Ravi & Ahmed, 2010). Unfortunately however, there have been several periodic recurrences of corporate governance frauds and failures in the country in recent years which imply that India’s governance reforms are not proactive but more reactive, being characterised as knee jerk reactions. Particular reference is given to the case of global software development and IT services firm Satyam Computers. In 2009, Satyam’s CEO took responsibility for broad accounting improprieties that overstated inflated cash balances of US$1.1 billion and profits by 97% (Balachandran, 2009). The investigation into the issue by various agencies uncovered that the CEO had resorted to practices such as forgery, asset stripping and income manipulation. Although the CEO and others were arrested, so far no one has been sentenced and the case has been ongoing in India’s courts for 5 years. This highlights the lack of power India’s legal judiciary has in punishing corporate wrong doing. Whilst regulation is highly important to try and ensure compliant corporate governance, more important is the capacity of the regulatory bodies to enforce and implement the provisions of their frameworks. This fraudulent activity from Satyam Computers clearly demonstrates that implementation of corporate governance in India is the main problem. It is without doubt that India possesses promising regulatory and legal fundamentals, however the lack of corporate governance implementation, as well as the fact that governance improvements may only be a calming reaction to fraudulent activity, makes India a risky looking investment for foreign investors.
Out of the BRIC economies, China attracted the largest amount of FDI in 2015 with an inflow amount of US$249.9 billion (UHY, 2015). This is partly due to the rapid expansion of the A-share market and also as a result of the opening of two stock exchanges: the Shanghai Securities Exchange and the Shenzhen Stock Exchange in 1990 and 1991 respectively. In 2002, China allowed Qualified Foreign Institutional Investors (QFII’s) to enter the domestic A-share market through a QFII scheme, allowing foreign investors to convert foreign currency into Chinese Yuan and invest it under a quota system (Huang & Zhu, 2015). It is important to consider however that QFII’s are subject to tight regulations. There are tight investment quotas imposed by the China Securities Regulatory Commission and in order to be able to invest, the foreign institutional investor must have had at least US$10 billion of assets under management in the previous financial year. As a result, the QFII’s that have invested thus far are exclusively large funds and investment banks, such as Goldman Sachs, UBS and Morgan Stanley, and not smaller investors. Foreign participation now only accounts for 1% of total stock market capitalisation (Clarke, 2015).
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Under the old centralised state planning system, the majority of firms were state-owned enterprises (SOE’s), in which the government had exclusive ownership and exerted tight control over enterprise decisions (Shen, 2016). Through various SOE reforms over the past 25 years, the state has gradually relinquished absolute control, remodelling many large formerly owned firms to implement Anglo-Saxon corporate governance structures. However, the government still remains the majority shareholder in 31% of Chinese publicly listed companies (Tian & Estrin, 2008). Empirical evidence given from Estrin & Prevezer (2011) strongly supports the contention that tight government ownership is detrimental to company performance.
Although Chinese economic growth has been rapid, foreign investors in China face a great challenge in protecting their property rights. This is because property rights were not formally recognised until 2004 and many foreign investors have found their property rights routinely violated by both public and private actions (Li, 2004). In addition, there is lack of legal infrastructure and weak contract enforcement (Cao, 2004). Therefore, expropriation of foreign investment due to the lack of property rights remains a pressing issue for foreign firms. Despite attracting large funds and investment banks into the A-share market, it is difficult for China to attract other investors for external capital. This makes China a BRIC economy that is not most likely to attract foreign investment.
In 2002, Brazil became the 6th largest economic power with a nominal GDP of $2 trillion (Clarke, 2015). In recent years, commendable efforts have been made at reform of the Brazilian corporate governance system in line with its new standing as a global power. In 2000, the Brazilian stock exchange BM+F Bovespa, created three high-governance listings – the Novo Mercado, Level I and Level II, offering high standards of corporate governance for firms wanting to attract increasing quantities of foreign capital (Black et al, 2014). In order to list on the Novo Mercado, the listing firm can only issue voting common shares and have a minimum free float (shares not controlled by controlling shareholders) of 25% (Black et al, 2010). Voting common shares allow smaller shareholders to vote on matters of corporate policy and the composition of the board of directors, enforcing their rights and minimising the risk of their expropriation. Listing on the Novo Mercado results in shareholdings becoming more diffuse, with boards of directors becoming more informed of their duties to exercise their decisions in the best interests of their companies. Furthermore, changes in the Brazilian Securities and Exchange Commission listing rules have raised disclosure standards and Bovespa requires additional financial disclosure for firms on its higher levels. For example, firms on Level I and higher must provide a statement of cash flows, with firms on Level II providing International Financial Reporting Standards.
In addition, many Brazilian firms have cross-listed on the New York Stock Exchange to signal their intent to maintain better levels of corporate governance. Figure 2 shows the number of Brazilian firms listed on the NYSE through the period 1995-2008, portraying that the number of firms cross-listing grew steadily through 2002. This presents a significant number of Brazilian firms wanting to harmonize their quality and disclosure of financial statements with the U.S. Generally Accepted Accounting Principles. Bigelli et al 2011) further suggests that cross-listing may dilute control and impose a cost on major shareholders.
Figure 2. Source: (Black et al, 2010)
The recent corruption scandal at Brazil’s huge majority-state-owned oil company Petrobas which ensnared dozens of politicians, such as former President Luiz Inacio Lula da Silva, is a prime example of the power of Brazil’s legal and judiciary efficiency. Unlike the case of Satyam Computers in India, the subsequent arrest of Brazil’s most powerful businessmen and political operators (The Guardian, 2016) in relation to the corruption at Petrobras highlights the power of the country’s multi-party democracy, free press and rule of the law in punishing wrong doing. Although this is evidence of corruption within the country, it should be a positive sign to investors that Brazil has the capacity to take meaningful attempts at preventing it. In particular, Brazil scores -3 in its anti-corruption index provided by Claessens & Yurtoglu (2013) which is significantly better than the other BRIC economies.
To conclude, it goes without saying that Brazil has the most favourable looking corporate governance environment to attract foreign investors into its markets. Despite the fact that China has been successful in attracting foreign investment as well, its A-share market and QFII scheme is subject to stringent rules and regulations that make it easy for only large investment funds to enter the capital markets. Additionally, many of China’s large companies are still state owned which still leaves significant ownership concentration. The challenge that investors face in protecting their property rights, as well as the lack of legal infrastructure leaves expropriation of foreign investment a pressing issue.
Despite corporate governance in Brazil remaining a work in progress, the creation of Novo Mercado has significantly improved the corporate governance structures of many large corporations. Such improvements have given minority shareholders a louder voice by allowing them to vote on matters such as corporate policy and board structure. The minimum free float of 25% minimises the risk of shareholder expropriation through dispersed ownership. This will lessen the risk of conflict between shareholders and managers and help ensure that managers act in the interest of the shareholders rather than their own. Furthermore, Brazil appears to be the strongest country out of the BRIC economies in actually enforcing shareholder rights, with enforcement remaining a struggling issue within the other economies. The only evident critique of Brazil is that many of its companies remain excluded from Novo Mercado and its other significant listings. As time goes by however, more and more countries should hopefully choose to list here, improving the corporate governance structure even further. Overall, Brazil stands out as the most favourable country to attract and secure foreign investment.
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