Interview: Do Foreign Investors Improve Corporate Governance in Emerging Markets?

Corporate Governance Insights Interview Series: Top corporate governance experts report on the latest research in emerging markets.


Kee-Hong Bae is a professor of finance at the Schulich School of Business of York University in Ontario, Canada. His research focuses on international finance with particular interest in emerging financial markets. 

The most interesting piece on corporate governance I read recently was…

Actually, it is a book I read quite some time ago called Saving Capitalism from the Capitalists by Raghuram G. Rajan and Luigi Zingales. The authors argue that in developing countries, those who would benefit most from the financial markets don’t have access to them, because a small group of the elite who are in power limit this access to protect their own entrenched interests. And because the financial system-and the entire economic system - is run by this small group and for this small group, the benefits of free financial markets are not easily obtainable to the general public. I think this is the essence of the governance problems in emerging markets. This small group, mostly controlling families of corporations, opposes governance improvements because doing so weakens their vested interests.

Rajan and Zingales posit a solution. They propose an “interest group” theory of financial development. This theory predicts that this group’s opposition to financial market development will be weaker when an economy allows both cross-border trade and capital flows, because it will be in their interests to do so. If this is true, one way to solve governance problems in emerging markets is to promote globalization, easing the flow of cross-border trade and capital.

Right now, I am working on…

A paper to be published in the Journal of Financial Economics called “Do Controlling Shareholders’ Expropriation Incentives Imply a Link between Corporate Governance and Firm Value? Theory and Evidence,” co-authored by Jaeseung Baek, Jun-Koo Kang, and Wei-Lin Liu.

The paper shows that the main channel through which governance affects firm value is the ability of controlling families to expropriate outsiders’ investments in the company.

What do I mean by this?

Suppose you have complete control over a $100m firm while you contribute only $100,000 in equity. So, outside investors hold a 99.9 percent ownership stake, and yet, by using a cross-holding or pyramidal ownership structure, you have all the decision-making power.

This gives you an incentive and an opportunity to appropriate company resources at the expense of outside shareholders. For example, the board that is controlled by you agrees to sell company assets such as land to your family members at below-market prices. Or you simply pay yourself an excessively high salary.

I think this has important implications for government policy-making in emerging markets. Policies that make it harder for controlling families to take advantage in this way, such as allowing outside shareholders to enter class-action law suits, will protect the shareholders’ rights and ultimately increase firm value.

A look at Korea before, during and after the 1997 Asian crisis seems consistent with this view. Before 1997, corporate boards played no role in monitoring management. The controlling families made the decisions and boards never actually met. Whenever the family required a sign-off from the board, they used an auto-pen! Before 1997, the notion of corporate governance was completely alien. And we know what happened, with the devastating crisis.

Since then, corporate governance in Korea has significantly improved thanks to several government-initiated governance reforms. One could argue that Korea withstood the 2008 global crisis much better than some other countries, at least partially because of this increased focus on governance. I think these reforms would not have been possible without external pressure to improve corporate governance.

I think the most relevant CG research topic for emerging markets now is…

Whether or not opening financial markets to foreign institutional investments does, in fact, lead to improved governance and better functioning markets.

There are two competing views. The first holds that if you open your markets, then international investors from countries with better governance institutions will play a monitoring role, and thus reduce governance-related problems. The second view suggests that foreign investors come and go at will, and they don’t contribute to local market development or institution-building. Rather, they invest, take profit, and leave. There is not a lot of empirical evidence to support either view, so we need more research to understand the role of the global investors and their impact on the governance of emerging market firms.

The latest development in the field of research on how foreign capital flows relate to the corporate governance environment in emerging markets is…

Foreign capital flows tend to increase more for better-governed firms.

The empirical evidence so far indicates that better-governed firms tend to attract more foreign capital. So, the implication for emerging market companies is that if you want to attract foreign capital, you need to improve your governance.

For further reading, Professor Bae recommends: 

"The Limits of Financial Globalization," Rene Stultz, Journal of Finance, 2005, v60(4), 1595-1638; reprinted in Journal of Applied Corporate Finance, 2007, v19(1), 8-15.


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