Equity pattern, corporate governance and performance
a study of India's corporate sector
Patibandla, Murali
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Publication date:
2001
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Citation for published version (APA):
Patibandla, M. (2001). Equity pattern, corporate governance and performance: a study of India's corporate
sector.
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Murali Patibandla
Equity Pattern, Corporate Governance
and Performance: A Study of
India’s Corporate Sector
WP 9 – 2001
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Equity Pattern, Corporate Governance and Performance: A Study of India’s
Corporate Sector
Murali Patibandla
Dept of International Economics and Management
Copenhagen Business School
Abstract:
In the literature on corporate governance, large outside investors are generally observed
to reduce agency costs of corporate governance by monitoring and disciplining managers.
This paper separates large investors into foreign investors and government owned local
financial institutions and argues that the later have higher degree of moral hazard. The
empirical results of the paper, based on firm level panel data for 11 Indian industries,
show that foreign investors contribute positively to corporate performance in terms of
profitability while the government financial institutions contribute negatively. Reducing
the role of government financial institutions and opening up of the equity markets to
foreign investors under effective regulatory mechanisms should improve corporate
governance in terms of increasing transparency in developing economies. This, in turn,
contributes positively to economic growth.
Keywords: foreign equity, government financial institutions, corporate governance
JEL classification: D2, G3, L2
First Draft: October 2001
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1. Introduction
Public savings are channeled into investment through multi-layer agency relations in an
economy as separation of ownership and control of capital operates pervasively right
from banks, pension funds, insurance companies, stock market and even paying taxes to
the government.
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Under the agency relations at different levels, market institutional
conditions that reduce informational imperfections and facilitate effective monitoring and
incentives of owners and agents of capital determine efficiency of investment. In the case
of corporate governance, efficiency of corporate investment is a function of institutional
factors such as the quality of auditing and disclosure which reduce informational
imperfection and the degree to which the legal and regulatory system that enforces
contracts (Stein, 2001). Information and monitoring of agents actions is also governed by
how the investors are organized into a large number of small investors and a few large
players. This, in turn, determines effectiveness of the legal system in protecting investors
interests (La Porta et al, 2000). The institutions that govern corporate governance are
different in different countries with varying degrees of protection of investors (Shleifer
and Vishny, 1997; Moerland, 1995). Countries, which have developed institutional
mechanisms to reduce the agency costs of investment, tend to utilize accumulated capital
more efficiently and realize higher economic growth compared to those with highly
inefficient institutional mechanisms.
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In several countries governments protect banking failures, which induce moral hazard on the
part of the banks in terms of reckless lending.
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One of the explanation for low economic growth in several developing economies
is observed to be under-developed financial markets and market institutions, which beset
high degree of agency costs at different levels (Beck et al, 2000). An example could be
Indian Economy in 1970s and 1980s, India achieved a high annual savings rate of 20
percent during the period but a very low economic growth rate of 3 percent (Bhagwati,
1993). One of the reasons could be misallocation and inefficient use of public savings by
the private and public sector financial institutions and corporations run by the public and
private agents with high degree of moral hazard. This problem gets magnified if the
product markets are non-competitive which allows managers to show high profits despite
overall inefficiency (Patibandla, 1998, 1997).
In the recent years there has been increasing globalization of financial markets.
The opening up of capital markets in several countries has increased not only the flow of
foreign investment into them but also the economic and political pressure to create
financial instruments acceptable to foreign investors. This has caused several forms of
functional convergence in institutional conditions across countries (La Porta et al, 2000;
Henry (2000); Stultz, 1999). In other words, the market reforms in several developing
and East European Economies have important implications on economic growth through
their implications on corporate governance.
Since the initiation of market reforms in 1991, Indian economy has grown at an
annual growth rate of 6 percent. One of the important elements of the reforms is opening
up to multinational investment and foreign financial institutions. This has implications on
the evolution of institutions of corporate governance. This paper examines the issue of
