1 Does Foreign Investment Really Improve Corporate Governance? Evidence from Thailand Sudarat Ananchotikul University of California, Berkeley This Draft: November 1, 2006 Abstract It is widely argued that foreign investment is a mechanism for improving corporate governance in emerging markets. This paper challenges this convention wisdom using firm-level data on 365 Thai firms listed on the Thai Stock Exchange. I construct a firm-specific index of the quality of corporate governance and use econometric methods to test the hypothesis that foreign investment has a positive effect. Endogeneity problems are addressed by using long-standing statutory limits on foreign ownership as an instrument for foreign investment. The results show that the form of foreign investment matters. When foreign industrial companies buy large stakes, there is no improvement in corporate governance; if anything the opposite is true. It appears that foreign industrial investors act as insiders: they favor weak corporate governance because it allows them to exploit minority shareholders. In contrast, purchases of minority stakes by foreign institutional investors lead to improvements in corporate governance. I also find that corporate governance is poorer for firms whose major foreign owner comes from a country with relatively weak governance institutions. I wish to express my deepest gratitude to Professor Barry Eichengreen for his continuous support, encouragement, and guidance during the research process. I am also indebted to Professor Pierre-Olivier Gourinchas, Professor Ann Harrison, Professor Ulrike Malmandier, Professor Edward Miguel, Professor Mark Seasholes, and Professor Akila Weerapana for very helpful comments. Financial support for data collection from the IBER mini-grant, UC Berkeley, is gratefully acknowledged. All errors are mine. *Department of Economics, University of California, Berkeley. Author’s e-mail contact: [email protected]. Introduction A popular view among policy makers is that foreign ownership positively influences firm performance and profitability. This view derives from the presumption that foreign investment is a conduit for technology, capital, managerial skills, training techniques and various intangibles that promote efficiency.1 Recently, good corporate governance has been added to the list of potential benefits.2 Surprisingly, however, there has been little systematic work on this relationship, especially for emerging market economies. This paper develops new evidence on the linkage. It shows that the effect of foreign investment on the quality of corporate governance is a good deal more complicated than commonly assumed and that its direction is sometimes contrary to what is conventionally supposed. Theories predicting a positive effect of foreign investment on corporate governance view foreign investors as outside shareholders. Foreign equity investment—whether it is in the form of joint ventures, multinational subsidiaries, takeovers, or even institutional portfolio investment—results in foreigners becoming outside blockholders with the ability (through voting rights) and the incentive (through cash-flow rights) to monitor incumbent management and force changes in behavior that are in the interest of outside shareholders as a class (Shleifer and Vishny, 1986). In addition, insofar as foreign corporate practices are superior to those prevailing in the host economy, foreign ownership participation may provide information and encourage the adoption of superior practices in areas such as information disclosure, internal checks and balances, and accounting standards (OECD, 2002). But do foreign investors always, in fact, act as minority investors seeking a better deal for outside shareholders? If they acquire a controlling stake in a domestic firm, they may then have the same incentive as other insiders to exploit minority shareholders. Ironically, the same sizeable ownership stake that positions foreign owners to monitor management can also give them an incentive to oppose governance reforms that undermine the position of the dominant blockholder. Since foreign companies often acquire management control when they invest in emerging market economies, it is at least conceivable that this perverse effect could be quite prevalent.3 1 See, among others, Dunning and Pearce (1977), Globerman (1979), Blomstrom (1986), Harrison (1996), Doms and Jensen (1998), and Kimura and Kiyota (2004)). 2 Since the quality of corporate governance is positively correlated with firm value (Black, 2002; Durnev and Kim, 2004; Klapper and Love, 2004), the link from foreign ownership participation to good governance and hence to high firm valuation seems to be a plausible direction of causality. 3 Moreover, in the case of Asian economies where hostile takeovers are rare and friendly negotiation is a customary way of doing business, foreign investors who become joint-venture partners tend to have personal ties with incumbent shareholders. The increase in value of equity holdings from monitoring thus may not generate sufficient motivation for foreign inside shareholders to press for more efficient behavior on the part of management. Rather,3Two theoretical arguments provide further grounds for questioning the existence of an unconditional positive relationship between foreign ownership and the quality of corporate governance. First, the entrenchment hypothesis of Morck, Shleifer, and Vishny (1988) predicts that more equity ownership by the manager worsens financial performance because managers with large ownership stakes may be so powerful that they do not have to consider other stakeholders’ interest. This situation may apply to foreign owners, especially foreign industrial corporations, since they usually participate in the firm’s management and operation. Second, the theory of private benefits of control due to Bebchuk (1999) explains why foreign inside shareholders may not have an incentive to improve corporate governance. It is their position as large shareholders that provides them with potential private benefits— private in the sense that they are not shared among all the shareholders in proportion of the shares owned—that they can enjoy with relative ease if corporate governance is weak.4 Whether foreign ownership contributes to good corporate governance is ultimately an empirical question. Unfortunately, two obstacles have stymied empirical work