In emerging market economies, the issuance of foreign securities can be a way for a firm to build its reputation among analysts, investors, and the business media. Foreign companies that list on their own exchanges and on U.S. exchanges such as NYSE and NASDAQ have to follow U.S. requirements with respect to corporate transparency and investor protection. This has been shown to increase corporate valuations and lower a foreign company’s cost of capital. Taking these benefits at face value, it is difficult to understand why so few firms utilize foreign financing opportunities.
This puzzle is the subject of the recent study “Political Relationships, Global Financing, and Corporate Transparency: Evidence from Indonesia,” by University of Chicago Graduate School of Business professor Christian Leuz and Felix Oberholzer-Gee of Harvard Business School.
The authors suggest that domestic arrangements—from political connections to long-standing relationships with domestic banks—may make global financing less attractive to firms. In addition, these arrangements may conflict with global financing, which typically involves scrutiny from foreign regulators, analysts, institutional investors, and the press. The decision to cross-list shares on foreign exchanges also forces firms to adapt to the regulations that govern these markets. These “hidden costs” of foreign financing help explain why relatively few companies finance themselves globally, even after the liberalization of their domestic markets.
“The core idea is that domestic opportunities, such as connections, significantly reduce the net benefits of foreign securities for some firms,” says Leuz. “For example, firms with political ties often receive cheap loans from state-owned banks, so they don’t really need foreign capital, and are unlikely to welcome the additional scrutiny that comes with publicly traded foreign securities.”
Leuz and Oberholzer-Gee examined the link between political connections and global financing using data from Indonesia. Indonesia’s crony capitalism under former President Haji Mohammad Suharto, who held office from 1967 to 1998— in addition to the Asian financial crisis and regime changes in Indonesia—proved to be an ideal testing ground to study this link as well as the performance consequences of foreign financing and political connections.
The authors find strong evidence that firms connected to the Suharto regime were significantly less likely to have publicly traded securities abroad.
“Our study is among the first to highlight the cost of global financing and hence provide reasons why firms might not want to pursue such financing,” says Leuz. “Prior studies have significantly understated the benefits of global finance, because the estimates didn’t account for the reasons why many firms do not seek foreign securities.”
The authors’ analysis shows that the advantages of foreign securities, both before and during the Asian crisis, are much larger when accounting for domestic arrangements.
Aside from the benefits of global financing, politically connected firms also incur significant political risk, for example, during regime changes. As the study shows, the performance of politically connected firms varies dramatically depending on the political fortunes of their backers.
After Suharto was forced to resign on May 21, 1998, longtime Suharto ally Jusuf Habibie took office. In October 1999, Habibie was replaced by Abdurrahman Wahid, a cleric who ran on an anti-establishment platform and promised to end cronyism in Indonesia. While there was little impact on company performance during the transition from Suharto to Habibie, the election of Wahid invalidated connections and had a substantially negative impact on firms connected to Suharto.
Measuring Political Connections
A key element of the study is measuring firms’ political relationships
with the Suharto regime. While these relationships
were reasonably well known to locals at the time, it is difficult
for researchers to measure connections in an objective and
accurate way.
Given this problem, the authors took an unusual approach to estimate political relationships. The authors examined the extent to which firms suffered losses when bad news about Suharto’s health hit the stock market, tracking stock market returns during six health-related events. This approach exploits that close political ties have important consequences for firm performance and are a source of firm value. Wellconnected firms may enjoy a range of benefits, such as lower taxes, low-cost financing, more business opportunities, and an easier time obtaining licenses.
“Our colleague Ray Fisman has shown that when Suharto was rushed to the hospital, closely connected firms suffered a larger drop in stock prices than less connected firms,” says Leuz. “Thus, we can use prices and stock market returns to infer the existence and strength of political connections.”
Leuz and Oberholzer-Gee applied this measure of connections to Indonesian firms for which they could obtain financial data and share prices. They also searched numerous databases for foreign debt or equity securities that were issued by Indonesian firms and were outstanding as of June 1997. The final sample consisted of 130 firms, representing the majority of the Indonesian market, of which 22 had publicly traded foreign securities.
The authors then examined whether firms closely connected to Suharto were more or less likely to have foreign securities. They controlled for a number of firm characteristics including: firm size, financial leverage, profitability, and industry. Their model explains a large part of the variation in firms’ foreign financing choices and provides strong evidence that firms with connections shy away from foreign finance.
As an alternative method of measuring connections, the authors looked at firms’ stock returns during the days leading up to Suharto’s resignation in 1998. Using stock market returns in response to the resignation, the authors continue to find that more closely connected firms were less likely to have foreign securities.
Finally, the authors constructed a family-based measure of political connections. Again, they find that companies owned by members of the Suharto family were less likely to have foreign securities. Thus, all three measures of political connections— stock returns during Suharto’s health crises, stock returns during Suharto’s resignation, and direct family-based measures—indicated that firms with strong political connections were less likely to have publicly traded foreign securities.
To see whether transparency considerations play an important role for their results, Leuz and Oberholzer-Gee examined the likelihood that closely connected firms tapped into foreign capital markets with privately arranged securities, such as syndicated loans from foreign banks. These securities allow access to global financing, but do not come with the same outside scrutiny and informational consequences as publicly traded securities.
They find that Indonesian firms with close ties to Suharto were as likely as nonconnected firms to have privately arranged foreign securities, indicating that transparency considerations do play a role in the tradeoff between political connections and foreign financing.
Crises and Regime Changes
Recent studies have shown that Asian firms with foreign
securities and higher-quality disclosures performed significantly
better during the Asian financial crisis of 1997–98.
However, the interpretation of these results depends crucially
on how the regime responded to economic turmoil and on
the support that Suharto’s cronies received during the crisis.
The authors analyzed the stock returns of the sample firms one year prior to and during the Asian financial crisis. Consistent with prior research, Indonesian firms with foreign finance and greater transparency performed better during the Asian financial crisis. However, these benefits were even larger after taking into account firms’ connections to the Suharto regime. The performance results show that connections were indeed valuable, suggesting that President Suharto lent considerable financial support to politically connected firms before and during the Asian financial crisis.
“The difference in stock returns between Indonesian firms with global financing and those connected to Suharto appears small if you ignore the support for his cronies during the crisis,” says Leuz. “Once the benefits of domestic arrangements are removed from the analysis, that’s when you see the real benefits of global financing.”
How do politically connected firms fare over longer periods of time? To address this issue, the authors studied the financial consequences of regime changes for firms with strong ties to Suharto.
Tracking returns across several regimes, the authors find that firms closely connected to Suharto underperformed during the Asian financial crisis, recovered under Suharto’s longtime ally Habibie, but significantly underperformed under Wahid, a cleric critical of the Suharto regime. These findings suggest that firms have difficulty reestablishing connections with a new government when their patron falls from power, and thatpolitical regime changes have a significant impact on the performance of companies invested in political relationships.
“After Wahid’s surprise election, the old Suharto connections appear to have been invalidated,” says Leuz. “This outcome presents an opportunity for us to redo our experiment by studying firms’ global financing choices after the Wahid election. If firms became more willing to raise foreign finance after the regime change, it is evidence that political connections were an important factor holding them back.”
Indeed, the authors find evidence that Suharto-connected firms responded to changes by adopting a more outwardoriented financing strategy during the Wahid regime. Firms that were closer to Suharto had a greater tendency to issue foreign securities after Wahid’s election.
These findings suggest a crucial link between capital market liberalization and political reform. Firms closely connected with the Suharto regime chose not to access global capital markets because the benefits of global financing remained small for them so long as they benefited from political connections. Once these connections lost their value, raising capital became more attractive.
Market Liberalization and Political Reform
Leuz and Oberholzer-Gee’s study sheds light on the difficulties
of institutional reform in emerging market economies like
Indonesia and points to the importance of political reform. The
impact of financial liberalization may be limited, or at least
muted, in economies where political connections are prevalent.
To the extent that foreign financing strengthens the position of less connected firms, firms with political clout can be expected to resist changes that will facilitate global financing, such as increases in corporate transparency.
“Firms are unlikely to take advantage of market liberalizations to the full extent if they still have their old domestic arrangements,” says Leuz. “In Indonesia, politically-connected firms did not globalize their financing practices until they lost their old connections to the regime. In that sense, political reform and capital market liberalization are complements. You need both in order to have a significant and lasting impact on firms’ financing practices.”
“Political relationships, global financing, and corporate transparency:
Evidence from Indonesia,” Christian Leuz and Felix Oberholzer-Gee,
Journal of Financial Economics, Vol. 81 (2006), pg. 411–439.