Corporate governance in emerging markets: A survey

Corporate governance in emerging markets: A survey

Emerging Markets Review 15 (2013) 1–33 Contents lists available at SciVerse ScienceDirect Emerging Markets Review journal homepage: www.elsevier.com...

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Emerging Markets Review 15 (2013) 1–33

Contents lists available at SciVerse ScienceDirect

Emerging Markets Review journal homepage: www.elsevier.com/locate/emr

Corporate governance in emerging markets: A survey ☆ Stijn Claessens a, B. Burcin Yurtoglu b,⁎ a b

Research Department, International Monetary Fund, University of Amsterdam, The Netherlands, CEPR and ECGI WHU–Otto Beisheim School of Management, Germany

a r t i c l e

i n f o

Article history: Received 5 July 2011 Received in revised form 20 January 2012 Accepted 2 March 2012 Available online 13 March 2012 JEL classification: G3 Keywords: Corporate governance Emerging markets Shareholder rights Performance Valuation Creditor rights Stakeholders

a b s t r a c t This paper reviews recent research on corporate governance, with a special focus on emerging markets. It finds that better corporate governance benefit firms through greater access to financing, lower cost of capital, better performance, and more favorable treatment of all stakeholders. Numerous studies show these channels to operate at the level of firms, sectors and countries—with causality increasingly often clearly identified. Evidence also shows that voluntary and market corporate governance mechanisms have less effect when a country's governance system is weak. Importantly, how corporate governance regimes change over time and how this impacts firms are receiving more attention recently. Less evidence is available on the direct links between corporate governance and social and environmental performance. The paper concludes by identifying issues requiring further study, including the special corporate governance issues of banks, and family-owned and state-owned firms, and the nature and determinants of public and private enforcement. © 2012 Elsevier B.V. All rights reserved.

Contents 1. 2. 3.

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . What is corporate governance? . . . . . . . . . . . . . . . . . . How do countries differ in aspects relevant to corporate governance? 3.1. The diversity in economic and financial environments . . . . 3.2. The diversity in institutional environments . . . . . . . . . 3.3. The diversity in ownership structures . . . . . . . . . . . . 3.4. The diversity in group affiliation and institutional investors . .

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☆ The views expressed here are those of the authors and do not necessarily represent those of the IMF or IMF policy. ⁎ Corresponding author. E-mail addresses: [email protected] (S. Claessens), [email protected] (B.B. Yurtoglu). 1566-0141/$ – see front matter © 2012 Elsevier B.V. All rights reserved. doi:10.1016/j.ememar.2012.03.002

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How and through what channels does corporate governance matter? . . . . . . 4.1. Increased access to financing . . . . . . . . . . . . . . . . . . . . . . 4.2. Higher firm valuation and better operational performance . . . . . . . . 4.3. Less volatile stock prices . . . . . . . . . . . . . . . . . . . . . . . . 4.4. Better functioning financial markets and greater cross-border investments 4.5. Better relations with other stakeholders . . . . . . . . . . . . . . . . . 4.5.1. Stakeholder management . . . . . . . . . . . . . . . . . . . 4.5.2. Social issue participation . . . . . . . . . . . . . . . . . . . 5. Corporate governance reform . . . . . . . . . . . . . . . . . . . . . . . . . 5.1. Recent country level reforms and their impact . . . . . . . . . . . . . . 5.1.1. Legal reforms . . . . . . . . . . . . . . . . . . . . . . . . . 5.1.2. Corporate governance codes and convergence . . . . . . . . . . 5.1.3. The role of firm-level voluntary corporate governance actions . . 5.1.4. Voluntary adoption of corporate governance practices . . . . . . 5.1.5. Boards . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.1.6. Cross-listings . . . . . . . . . . . . . . . . . . . . . . . . . 5.1.7. Other mechanisms . . . . . . . . . . . . . . . . . . . . . . 5.1.8. The role of political economy factors . . . . . . . . . . . . . . 6. Conclusions and areas for future research . . . . . . . . . . . . . . . . . . . Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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1. Introduction Corporate governance, a phrase that a decade or two ago meant little to all but a handful of scholars and shareholders, has become a mainstream concern—a staple of discussion in corporate boardrooms, academic meetings, and policy circles around the globe. Several events are responsible for the heightened interest in corporate governance. During the wave of financial crises in 1998 in Russia, Asia, and Brazil, the behavior of the corporate sector affected entire economies, and deficiencies in corporate governance endangered global financial stability. Just a few years later confidence in the corporate sector was sapped by corporate governance scandals in the United States and Europe that triggered some of the largest insolvencies in history. And the most recent financial crisis has seen its share of corporate governance failures in financial institutions and corporations, leading to systemic consequences. In the aftermath of these events, not only has the phrase corporate governance become more of a household term, but also researchers, the corporate world, and policymakers everywhere recognize the potential macroeconomic, distributional and long-term consequences of weak corporate governance systems. The crises, however, are just manifestations of a number of structural reasons why corporate governance has become more important for economic development and well-being. The private, market-based investment process is much more important for most economies than it used to be, and that process needs to be underpinned by good corporate governance. With firms increasing in size and the role of financial intermediaries and institutional investors growing, the mobilization of capital is increasingly one step removed from the principal–owner. At the same time, the allocation of capital has become more complex as investment choices have widened with the opening up and liberalization of financial and real markets, and as structural reforms, including price deregulation and increased competition, have increased companies' exposure to market forces risks. At the same time, the recent financial crisis has reinforced how failures in corporate governance can ruin corporations and adversely affect whole economies. These developments have made the monitoring of the use of capital more complex in many ways, enhancing the need for good corporate governance. This paper traces the many dimensions through which corporate governance works in firms and countries. To do so, it reviews the extensive literature on the subject—and identifies areas where more study is needed. A large body of research has over the last two decades documented the importance of legal foundations, including the quality of the corporate governance framework, for economic development. Research has shown links between law and economics, highlighting the roles of legal foundations and welldefined property rights for properly functioning market economies. This literature has also addressed the

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importance and impact of corporate governance. 1 Research, however, has expanded less into emerging markets and even less so to developing countries, and much work still refers to situations in developed countries, in particular the United States. Furthermore, research often focuses on the relationship between corporate governance and economic development and not on other measures of well-being. The purpose of this paper is to fill these gaps. The paper is structured as follows. It starts with a definition of corporate governance, as that determines the scope of the issues, and reviews how corporate governance can and has been defined. The paper next explores in which ways corporate governance may matter, and especially how it affects corporations in emerging markets. It does so by providing extensive background on countries' economic, financial and institutional environments, including ownership patterns, around the world that determine and affect the scope and nature of corporate governance problems. This section highlights that corporate governance issues in emerging markets vary from those in advanced countries due to still-limited development of private financial markets and poor access to financing, concentrated ownership structures, and low institutional ownership. After showing some of the differences among emerging markets, such as the variation in governance structures between East Asia and recent EU-member Central and Eastern Europe countries, this section also documents the differences in levels of market pressures, political/government influence, capital cost controls, internalization of stakeholder interests, governance spillovers through inward FDI, outward FDI and tapping of international capital markets among emerging markets and between emerging markets and advanced countries. These issues help set the stage of the remaining discussion in the paper. After analyzing what the theoretical literature has to say about the various channels through which corporate governance affects economic development and well-being, the paper reviews the empirical facts about these relations. It explores recent research documenting how (changes in) legal aspects can affect firm valuation, influence the degree of corporate governance problems, and more broadly affect firm performance and financial structure. It then reviews the evidence on how a number of (voluntary) corporate governance mechanisms – ownership structures, boards, cross-listing, use of independent auditors – affect firm performance and behavior. It also reviews research on the factors that play a role in countries' willingness to undertake corporate governance reforms. The paper concludes by identifying some main policy and research issues that require further study. 2. What is corporate governance? Definitions of corporate governance vary widely. They tend to fall into two categories. The first set of definitions concerns itself with a set of behavioral patterns: that is, the actual behavior of corporations, in terms of such measures as performance, efficiency, growth, financial structure, and treatment of shareholders and other stakeholders. The second set concerns itself with the normative framework: that is, the rules under which firms are operating—with the rules coming from such sources as the legal system, the judicial system, financial markets, and factor (labor) markets. For studies of single countries or firms within a country, the first type of definition is the most logical choice. It considers such matters as how boards of directors operate, the role of executive compensation in determining firm performance, the relationship between labor policies and firm performance, and the role of multiple shareholders. For comparative studies, the second type of definition is the more logical one. It investigates how differences in the normative framework affect the behavioral patterns of firms, investors, and others. In a comparative review, the question arises how broadly to define the framework for corporate governance. Under a narrow definition, the focus would be only on the rules in capital markets governing equity investments in publicly listed firms. This would include listing requirements, insider dealing arrangements, disclosure and accounting rules, and protections of minority shareholder rights. Under a definition more specific to the provision of finance, the focus would be on how outside investors protect themselves against expropriation by the insiders. This would include minority right protections and the strength of creditor rights, as reflected in collateral and bankruptcy laws, and their enforcement. It could also include such issues as requirements on the composition and the rights of the executive directors and the ability to pursue class-action suits. This definition is close to the one advanced 1 The first broad survey of corporate governance was Shleifer and Vishny (1997). Several surveys have since followed, including Becht et al. (2003), Claessens and Fan (2002), Denis and McConnell (2003), and Holmstrom and Kaplan (2001).

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by Shleifer and Vishny in their seminal 1997 review: “Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment” (1997, p. 737). This definition can be expanded to define corporate governance as being concerned with the resolution of collective action problems among dispersed investors and the reconciliation of conflicts of interest between various corporate claimholders. A somewhat broader definition would be to define corporate governance as a set of mechanisms through which firms operate when ownership is separated from management. This is close to the definition used by Sir Adrian Cadbury, head of the Committee on the Financial Aspects of Corporate Governance in the United Kingdom: “Corporate governance is the system by which companies are directed and controlled” (Cadbury Committee, 1992). An even broader definition is to define a governance system as “the complex set of constraints that shape the ex post bargaining over the quasi rents generated by the firm” (Zingales, 1998, p. 499). This definition focuses on the division of claims and can be somewhat expanded to define corporate governance as the complex set of constraints that determine the quasi-rents (profits) generated by the firm in the course of relationships with stakeholders and shape the ex post bargaining over them. This definition refers to both the determination of value-added by firms and the allocation of it among stakeholders that have relationships with the firm. It can be read to refer to a set of rules, as well as to institutions. Corresponding to this broad definition, the objective of a good corporate governance framework would be to maximize the contribution of firms to the overall economy—that is, including all stakeholders. Under this definition, corporate governance would include the relationship between shareholders, creditors, and corporations; between financial markets, institutions, and corporations; and between employees and corporations. Corporate governance would also encompass the issue of corporate social responsibility, including such aspects as the dealings of the firm with respect to culture and the environment. When analyzing corporate governance in a cross-country perspective, the question arises whether the framework extends to rules or institutions. Here, two views have been advanced. One is the view that the framework is determined by rules, and related to that, to markets and outsiders. This has been considered a view prevailing in or applying to Anglo-Saxon countries. In much of the rest of the world, institutions – specifically banks and insiders – are thought to determine the actual corporate governance framework. In reality, both institutions and rules matter, and the distinction, while often used, can be misleading. Moreover, both institutions and rules evolve over time. Institutions do not arise in a vacuum and are affected by the rules in the country or the world. Similarly, laws and rules are affected by the country's institutional setup. In the end, both institutions and rules are endogenous to other factors and conditions in the country. Among these, ownership structures and the role of the state matter for the evolution of institutions and rules through the political economy process. Shleifer and Vishny (1997, p. 738) take a dynamic perspective by stating: “Corporate governance mechanisms are economic and legal institutions that can be altered through political process.” This dynamic aspect is very relevant in a cross-country review, but has received attention from researchers only lately. When considering both institutions and rules, it is easy to become bewildered by the scope of institutions and rules that can be thought to matter. An easier way to ask the question of what corporate governance means is to take the functional approach. This approach recognizes that financial services come in many forms, but that if the services are unbundled, most, if not all, key elements are similar (Bodie and Merton, 1995). This line of analysis of the functions – rather than the specific products provided by financial institutions, and markets – has distinguished six types of functions: pooling resources and subdividing shares; transferring resources across time and space; managing risk; generating and providing information; dealing with incentive problems; and resolving competing claims on the wealth generated by the corporation. One can operationalize the definition of corporate governance as the range of institutions and policies that are involved in these functions as they relate to corporations. Both markets and institutions will, for example, affect the way the corporate governance function of generating and providing high-quality and transparent information is performed. 3. How do countries differ in aspects relevant to corporate governance? The nature of the corporate governance challenges is importantly determined by the countries' overall development and institutional environment, and specifically by prevailing ownership structures. This section

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Table 1A Macroeconomic and financial indicators. Country

Australia Austria Belgium Canada Denmark Finland France Germany Greece Iceland Ireland Italy Japan Luxembourg Netherlands New Zealand Norway Portugal Spain Sweden Switzerland United Kingdom United States Developed (avg) Argentina Bolivia Brazil Chile China Colombia Ecuador Egypt, Arab Rep. El Salvador Ghana Hong Kong, China India Indonesia Israel Jamaica Jordan Kenya Korea, Rep. Malaysia Mexico Morocco Nigeria Pakistan Panama Peru Philippines Singapore South Africa Sri Lanka Taiwan Thailand Tunisia

Per capita GDP

GDP growth

Trade

Foreign direct investment

Private credit

Market capitalization

Stocks traded

2005 USD

Annual %

% of GDP

% of GDP

% of GDP

% of GDP

% of MC

32,248 33,475 31,866 34,369 32,808 30,274 29,519 31,727 24,179 33,277 36,936 28,055 29,841 67,207 35,322 24,430 46,475 21,425 26,956 31,927 35,946 32,068 41,584 33,561.5 10,922 3648 8559 11,900 4164 7321 6537 4423 5680 1198 34,753 2284 3204 23,645 6922 4297 1342 22,439 11,567 12,516 3493 1697 2136 9464 6436 2897 42,358 8533 3568 . 6563 6414

3.2 1.7 1.5 2.1 0.9 2.1 1.4 0.8 3.4 3.1 3.8 0.5 0.7 3.4 1.6 2.4 2.0 0.9 2.6 2.0 1.7 1.7 1.8 2.0 3.6 3.7 3.3 3.7 10.3 4.0 4.5 4.9 2.1 5.5 4.2 7.2 5.1 3.6 1.1 6.3 3.6 4.4 4.8 1.9 4.8 6.1 4.6 5.8 5.1 4.6 5.6 3.6 5.0 . 4.1 4.7

40.3 100.7 154.0 72.8 92.9 78.2 53.2 75.4 56.1 79.9 161.5 52.8 26.1 289.2 131.7 60.4 72.8 67.3 57.2 88.8 90.8 56.7 26.0 86.3 38.3 61.4 25.7 71.9 57.6 35.8 65.2 54.2 69.9 89.1 353.5 37.9 59.3 77.8 98.6 125.6 60.1 79.4 200.5 57.0 69.0 73.3 32.2 140.5 41.6 93.9 406.5 59.0 72.7 . 134.0 101.9

2.8 6.1 21.7 3.7 3.9 3.1 3.0 2.4 0.9 9.4 6.7 1.3 0.2 347.0 6.8 3.0 1.7 3.0 3.7 5.0 4.8 4.6 1.5 19.4 2.3 3.7 2.7 6.5 3.1 3.4 1.6 3.8 2.7 3.2 20.7 1.6 0.5 4.1 6.5 10.5 0.6 0.7 2.9 2.9 2.2 3.3 1.8 7.0 3.3 1.5 14.2 1.9 1.3 . 3.6 4.3

115.8 128.1 112.4 184.1 178.7 74.9 112.1 136.0 91.8 184.1 153.7 112.0 304.6 . 175.1 128.8 75.9 152.2 160.7 112.4 176.9 166.7 219.2 148.0 38.0 57.5 81.3 88.6 134.0 33.0 20.5 92.3 45.6 30.0 140.4 59.9 46.8 79.6 56.1 95.3 39.6 95.0 130.3 35.5 80.3 17.7 44.0 89.9 19.9 54.8 76.9 175.2 43.4 . 127.7 72.4

114.9 28.9 68.1 112.4 62.7 117.8 83.7 47.8 57.7 102.1 53.9 43.2 77.5 163.3 99.5 37.2 53.7 41.1 86.9 104.8 245.7 132.3 127.1 89.7 42.8 18.9 51.4 104.2 65.9 27.7 7.7 54.8 19.2 14.3 483.3 61.9 26.6 79.7 80.3 147.7 28.8 66.3 135.5 26.2 50.9 19.6 24.1 27.6 42.4 45.8 182.2 202.4 16.1 . 55.7 13.3

80.9 39.7 42.6 76.0 83.0 116.0 101.1 139.4 48.3 69.8 49.0 123.6 107.2 1.0 147.7 51.0 115.1 68.5 174.4 124.3 100.5 139.2 196.1 95.4 10.4 0.9 46.0 14.3 121.9 9.8 6.4 35.6 4.5 3.0 63.0 138.9 51.5 58.5 2.8 41.6 7.7 248.0 33.1 28.4 21.0 14.5 289.4 2.3 7.8 18.7 66.4 47.4 18.1 . 88.8 14.7

(continued on next page)

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Table 1A (continued) Country

Turkey Uganda Uruguay Venezuela, RB Zimbabwe Emerging markets (avg) Bulgaria Croatia Czech Republic Hungary Kazakhstan Latvia Lithuania Poland Romania Russian Federation Slovak Republic Ukraine Transition (avg)

Per capita GDP

GDP growth

Trade

Foreign direct investment

Private credit

Market capitalization

Stocks traded

2005 USD

Annual %

% of GDP

% of GDP

% of GDP

% of GDP

% of MC

10,472 914 9915 9998

3.8 7.2 2.3 3.9 -5.9 4.2 4.7 3.3 3.4 2.7 8.6 4.8 4.8 3.9 4.5 5.5 4.5 4.7 4.6

48.7 42.0 51.9 50.9 82.8 89.4 115.4 89.6 138.0 142.7 93.3 98.3 115.0 72.9 74.6 56.9 162.8 104.0 105.3

27.4 0.9 0.6 4.6 148.1 66.8 16.5 36.4 26.0 24.7 22.0 9.7 19.3 26.4 14.6 56.3 6.3 21.9 23.3

156.6 2.1 3.9 6.3 13.2 47.2 19.2 6.2 63.8 76.4 13.5 13.2 11.8 37.6 14.9 54.0 24.8 6.0 28.5

. 8919.4 9563 14,940 19,981 16,178 8306 12,267 13,506 13,899 9196 11,574 16,207 5290 12,575.6

1.7 4.1 3.8 1.3 0.7 3.9 13.8 5.8 6.0 14.5 9.2 4.2 3.6 3.9 5.2 2.4 4.8 4.3 6.5

47.9 9.4 48.3 15.7 78.3 66.7 39.4 60.9 49.6 63.6 28.0 62.0 38.8 43.2 25.3 25.9 50.8 45.1 44.4

Definitions of the indicators and their sources Indicator

Definition

Period

Source

Per capita GDP GDP growth

GDP per capita, PPP in constant 2005 international USD. Annual percentage growth rate of GDP at market prices based on constant local currency. Sum of exports and imports of goods and services measured as a share of gross domestic product. Foreign direct investment, net inflows as a share of gross domestic product. Domestic credit to private sector as a share of gross domestic product. Market capitalization of listed companies as a share of gross domestic product. Total value of shares traded divided by the average market capitalization for the period.

2000–2010 2000–2010

WDI WDI

2000–2010

WDI

2000–2010

WDI

2000–2010

WDI

2000–2010

WDI

2000–2010

WDI

Trade Foreign direct investment Private credit Market capitalization (MC) Stocks traded

therefore provides for advanced countries, emerging markets and transition economies salient statistics on both countries' economic and financial environment as well as key aspects of their institutional environments, such as ease of contracting and the degree of legal and judicial efficiency, with many measures and their relations with good corporate governance discussed in greater detail in the next sections. These comparisons highlight that emerging markets differ in some key aspects from advanced countries, but also show much variation in some of these aspects across emerging markets. Since corporate governance issues and the role of corporate governance for economic development are best understood from the perspective of ownership structures and the related structures of business groups, the section next provides a review of the wide variety in ownership concentration and business group structures across countries. The comparisons naturally lead to subsequent discussions of the key corporate governance issues in emerging markets.

3.1. The diversity in economic and financial environments Economic and financial conditions obviously differ greatly among countries. Table 1A reports, for a sample of advanced countries, emerging markets and transition economies, key aspects importantly influencing corporate governance. First, it reports economic development and prospects. In terms of GDP

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Table 1B Governance indicators. Country

Legal origin

Legal Creditor Legal protection Efficiency Anti Disclosure Corporate rights strength rights of minority of debt corruption requirements governance shareholders enforcement opacity

Australia Austria Belgium Canada Denmark Finland France Germany Greece Iceland Ireland Italy Japan Luxembourg Netherlands New Zealand Norway Portugal Spain Sweden Switzerland United Kingdom United States Developed (avg) Argentina Bolivia Brazil Chile China Colombia Ecuador Egypt, Arab Rep. El Salvador Ghana Hong Kong, China India Indonesia Israel Jamaica Jordan Kenya Korea, Rep. Malaysia Mexico Morocco Nigeria Pakistan Panama Peru Philippines

British 9.0 German 7.0 French 7.0 British 6.0 Scandinavian 8.7 Scandinavian 7.0 French 5.8 German 7.7 French 3.0 Scandinavian 7.0 British 8.0 French 3.0 German 6.8 French 7.0 French 6.0 British 10.0 Scandinavian 7.0 French 3.0 French 6.0 Scandinavian 4.8 German 8.0 British 9.0

3 3 2 1 3 1 0 3 1 . 1 2 2 . 3 4 2 1 2 1 1 4

79 21 54 65 47 46 38 28 23 24 79 39 48 25 21 95 44 49 37 34 27 93

87.8 78.0 90.8 93.2 76.7 92.4 54.1 57.0 53.8 . 89.9 45.3 95.5 . 94.9 90.7 91.8 82.3 82.0 86.0 60.4 92.3

196 198 137 205 244 242 137 188 38 218 160 33 119 195 215 235 210 113 119 225 212 190

50 67 58 42 50 58 67 83

21 13 13 20 21 13 10 12 7 0 16 10 10 6 18 16 17 2 6 21 14 14

British

8.0

1

65

85.8

152

100

21

6.7

2.0

46.9

80.0

173.1

French French French French German French French French

4.0 1.0 3.0 4.0 4.8 5.0 3.0 3.0

1 2 1 2 2 0 0 2

44 8 29 63 78 58 8 49

35.8 . 13.4 40.9 43.6 64.8 19.4 28.6

− 40 − 59 −3 142 − 47 − 26 − 86 − 46

French British British

5.0 6.5 10.0

3 1 4

57 73 96

37.8 . 88.3

− 46 − 12 179

British French British British French British German British French French British British French French French

7.2 3.0 9.0 8.0 4.0 10.0 7.0 10.0 5.0 3.0 8.0 6.0 6.0 5.7 3.0

2 2 3 2 1 4 3 3 0 1 4 1 4 0 1

55 68 71 35 16 22 46 95 18 57 52 41 15 41 24

. 25.1 66.2 69.0 44.5 . 88.1 48.4 72.6 41.9 . . 43.0 41.8 17.5

− 40 − 82 99 − 41 17 − 95 41 28 − 28 − 14 − 110 − 94 − 31 − 27 − 56

Index

Index

Index

Index

Index

Index 75 25 42 92 58 50 75 42 33 . 67 67 75 .

60.7 50

Index

13.1 8

. 25 58 . 42 0 50

. 10 13 5 5 . 4

. .

. . .

92 92 50 67

7 9 16 .

67 50 75 92 58

. 7 10 .

. 67 58

9 6 6 18 14

. 33 83

. 8 9

(continued on next page)

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Table 1B (continued) Country

Legal origin

Singapore South Africa Sri Lanka Taiwan Thailand Tunisia Turkey Uganda Uruguay Venezuela, RB Zimbabwe Emerging markets (avg) Bulgaria Croatia Czech Republic Hungary Kazakhstan Latvia Lithuania Poland Romania Russian Federation Slovak Republic Ukraine Transition (avg)

British British British German British French French British French French

Anti Disclosure Corporate Legal Creditor Legal protection Efficiency corruption requirements governance of debt rights strength rights of minority opacity enforcement shareholders Index

Index

Index

Index

10.0 9.0 3.3 4.0 3.0 4.0 7.0 5.0 2.0

3 3 2 2 2 0 2 2 3 3

100 81 41 56 85 17 43 41 17 9

96.1 39.8 45.7 93.8 54.9 56.6 6.6 . 28.6 13.1

Index 226 40 − 24 67 − 24 1 − 18 − 82 96 − 98

Index

Index

100 83 75 75 92 . 50 . 0 17

9 16 7 0 8

British

6.0 5.5

4 2.0

44 47.3

. 47.1

− 116 − 11.0

50 58.9

German German German

8.0 5.3 6.7

2 3 3

66 25 34

46.0 45.0 40.7

− 20 −7 37

. . .

12 3 18

German French German French German French French

7.0 4.0 9.0 5.0 8.2 7.5 3.0

1 2 3 2 1 1 2

20 48 35 38 30 41 48

46.7 31.4 49.3 58.7 67.7 11.0 39.0

55 − 100 4 14 36 − 28 − 92

. . . . . . .

2 11 10 11 10 11

German

9.0

2

29

58.9

27

.

0

French

8.3 6.8

2 2.0

11 35.4

17.5 42.7

− 91 − 13.8

. .

0 8.0

. 11 . . 23 . 9.5

.

Definitions of the indicators and their sources Indicator

Definition

Period

Source

Legal origin Legal rights strength

Legal origin. Strength of legal rights index (0 = weak, 10 = strong) Creditor rights aggregate score (0 = weak, 4 = strong). Anti-self-dealing index in bp (0 = weak, 100 = strong). Efficiency of debt enforcement (0 = weak, 100 = strong). Average corruption score (higher numbers mean “less corrupt”). Disclosure requirements index in bp (0 = weak, 100 = strong).

1999 2000–2010 2007

La Porta et al. (1999) WDI (World Development Indicators, World Bank) Djankov et al. (2007)

2006

La Porta et al. (2006)

2006–2008

Djankov et al. (2008a)

1996–2000

WGI (Worldwide Governance Indicators, World Bank Institute) La Porta et al. (2006)

Creditor rights Legal protection of minority shareholders Efficiency of debt enforcement Anti corruption Disclosure requirements

2006

per capita (column 1), emerging markets and transition economies rank still much below advanced countries. Some emerging markets, though, such as Hong Kong and Singapore, exceed in terms of per capita income in many advanced countries, while others, such as Korea and Hungary, are ahead or not far behind some advanced countries. As is well known, GDP growth has been much higher recently in emerging markets and transition economies than in advanced countries (column 2), almost double. Important impetus for corporate governance improvements has been the internationalization and globalization in trade and finance. The next column (3) shows that in terms of trade integration emerging

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markets and transition economies do not differ anymore much from advanced countries, although there are large differences among emerging markets (e.g., East Asian countries are typically much more open). Foreign direct investment (FDI) as a percent of GDP (column 4) still differs much across countries, with emerging markets and transition economies relying much less on FDI, than advanced countries do. There are differences though among emerging markets, with some East Asian countries much more reliant on FDI. Another important force has been financial market pressures. Here, however, there remain relatively large differences among countries, as shown by the ratio of credit to GDP (column 5). Advanced countries have much deeper financial systems, with ratios more than double those of emerging markets and almost three times those of transition economies. But the variation among emerging markets is very large as well. Many countries in East Asia, for example, have ratios close to or more than 100%, whereas many Latin American countries have ratios only half those. Also, some transition economies like Poland and Romania score relatively low in this respect, a reflection of episodes of high inflation. Differences also exist in stock market development. Market capitalization as a share of GDP (column 6) is some 90% in advanced countries, versus 67% in emerging markets and only 23% in transition economies. Again, the differences among emerging markets are large. Besides many transition economies, Latin American countries tend to have low stock market development. In terms of the frequency at which stocks are being traded, measured by the turnover ratio (column 7), emerging markets are more similar to advanced countries, but transition economies show much lower turnover ratios than advanced countries do. 3.2. The diversity in institutional environments Table 1B presents some salient institutional dimensions that matter for corporate governance and financial markets development in general. Crucial are properly functioning legal and judicial systems. This involves a number of dimensions: the general legal definition and protection of property rights, and that of creditor and shareholder rights specifically; the enforcement of legal rights by the judicial system; the lack of corruption in general; and the overall disclosure and transparency regime, especially that related to corporate governance. Many of these aspects are of a qualitative nature and consequently not easily captured and codified. The comparisons nevertheless show some clear differences between countries. The starting point for describing the legal system is often its origin (column 1): Common Law (British) or Civil Law, with the latter French or German in origin (a smaller category is Scandinavian), with Common Law is generally considered to be better in terms of the overall strength of (formal) property rights protection. On this score, reflecting past colonization, emerging markets do not differ much from advanced countries, but transition economies do in that they all have Civil Law origin. The strength of countries' formal legal rights, captured using an index based on various legal features (column 2), shows little differences between advanced countries and transition economies, but emerging markets tend to have less strongly defined rights. Formal rights are particularly weak in some African, Latin America and Middle Eastern countries and tend to be better in common law origin emerging markets. The rights of creditors and shareholders (column 3 and 4) are on average equally strongly defined in advanced countries as in emerging markets and transition economies, except for shareholder rights which are less strongly defined in transition economies. Still, these averages hide large variations, reflect in part legal origins. In many emerging market countries, formal rights of creditors are very weak (in Colombia, Egypt, and Mexico, for example, the score is a zero). Also shareholder rights are often very weak, especially in Latin America (scores in Bolivia, Ecuador, and Venezuela are less than 10 on a scale of 100). What matters too is the degree of enforcement of formal rights. This aspect, while obviously hard to codify, is captured in the efficiency of enforcement (column 5) and the lack of corruption (column 6) indexes. These show much larger differences than the formal rights do. On average, enforcement is twice as high in advanced countries than in emerging markets and transition economies. Also, corruption is much less, but with again large variation. Some emerging markets like Chile, Hong Kong and Singapore score above many advanced countries, while others dramatically fail to curb corruption (e.g., Kenya and Nigeria). The next index shows the degrees to which corporations listed on local stock exchanges have to disclose relevant financial and other information (column 7). Differences between advanced countries and emerging markets are not large on average (data do not cover transition economies), but there is much more variation among emerging markets. Malaysia, Thailand and South Africa have disclosure requirements that equal or

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exceed those of most advanced countries, while those of others, such as Brazil, Ecuador, Uruguay and Venezuela, are very weak. An index of de-facto quality of corporate governance, based on actual corporations' behavior – how accounting statements are being provided, earnings are being smoothed, and stock prices behave and reflect information about the firm – is shown next (column 8). It shows emerging markets and transition economies to score below advanced countries as a group, with again large differences among emerging markets.

3.3. The diversity in ownership structures The nature of the corporate governance problems importantly varies by ownership structures. For an individual firm, ownership structure defines the nature of principal–agent issues. Here the difference between direct ownership – also called cash-flow rights – and control rights – who de facto runs the corporation, also called voting rights – is very important. In many corporations, the controlling shareholder may have little direct equity stake, but through various constructions she may still exercise de facto full control. Another factor is group-affiliation, especially important in emerging markets, where business groups can dominate economic activity. Of course, ownership and group-affiliation structures vary over time and can be endogenous to country circumstances, including economic and financial conditions, and legal and other foundations (Shleifer and Vishny, 1997). As such, ownership and groupaffiliation structures both are affected by and affect legal and regulatory infrastructures. Much of the early literature focused on conflicts between managers and owners. But around the world, except for the United States and to some degree the United Kingdom, insider-controlled or closely-held firms are the norm (La Porta et al., 1998). Firms can be family-owned or financial institutions-controlled. Families like the Peugeots in France, Quandts in Germany, and Agnellis in Italy hold large blocks of shares in and effectively control the largest firms (Barca and Becht, 2001; Faccio and Lang, 2002). Even in the United States, family-owned firms are not uncommon (Holderness, 2009). In Japan and to some extent Germany, financial institutions control large many corporations (Claessens et al., 2000; Faccio and Lang, 2002; La Porta et al., 1998). This control is frequently reinforced through pyramids and webs of shareholdings that allow families or financial institutions to use ownership of one firm to control many more with little direct investment. Most studies document a large shareholder with a controlling direct interest in listed companies in emerging markets (Table A2 2 summarizes). In the East Asian countries Hong Kong, Indonesia, and Malaysia, the largest direct shareholdings, often families and also involved with management, own generally about 50%. Direct equity ownership is typically slightly more than 50% in India and Singapore, and less so in S. Korea (~ 20%), Taiwan (~30%), and Thailand (~40%). Financial institutions also have sizeable ownership stakes in Bangladesh, Malaysia, India and Thailand. Some corporations in India, Indonesia, Malaysia and Korea are foreign owned. Also some state ownership is reported in India, Malaysia, and Thailand, albeit by studies from the 1990s. A large divergence between cash flow and voting rights of controlling owners is reported for many East Asian corporations, with this divergence mostly maintained by pyramid structures. In Latin America, the typical largest shareholder owns more than 50% and even more than 60% in Argentina and Brazil. Similar to East Asia, most of the largest shareholders are wealthy families. In Chile, Colombia, Mexico and Peru, financial and non-financial companies are also direct owners. In contrast to East Asia, non-voting stock and dual-class shares are more prevalent and divergence of cash flow rights from voting rights is consequently more common in Latin America. Studies from Israel, Kenya, Turkey, Tunisia and Zimbabwe also point towards concentrated ownership and a large divergence of cash flow rights from control rights. As such, this pattern seems to be the norm around the world. Limited research mostly reports that ownership structures are fairly stable over time, except for transition countries. Foley and Greenwood (2010) study the evolution of ownership in 34 countries. Almost everywhere, ownership tends to be concentrated following their initial public offering (IPO). In countries with strong protections for minority investors and liquid stock markets, though, the typical firm becomes widely held within 5 to 7 years. In the United States, for example, median block ownership drops from 50% to 21% within 5 years. Nearly everywhere else, however, firms remain closely held even 10 years after going public. In Brazil block holders still own half of the median firm 5 years after IPO. Carney and 2

Tables A2–A8 can be downloaded from http://www.whu.edu/uploads/media/_Appendix__Tables_2-8__01.pdf.

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Child (in press) analyze ownership changes in East Asia from 1996 to 2008 and report that family control remains the most common form of ownership (less so among Northeast Asian firms and more so among Southeast Asian firms). Ownership structures affect the nature of the agency problems between managers and outside shareholders, and among shareholders. When ownership is diffuse, as is typical in the U.S. and the U.K., agency problems stem from the conflicts of interests between outside shareholders and managers who own little equity in the firm (Jensen and Meckling, 1976). In such countries, controlling management actions is often key. When ownership is concentrated to a degree that one owner (or a few owners acting in concert) has effective control of the firm, the nature of the agency problem shifts away from manager– shareholder conflicts. Information asymmetries can be assumed to be less, as the controlling owner is often also the manager or can otherwise be assumed to be able and willing to invest the resources necessary to closely monitor and discipline management. Rather, since insider-held firms dominate, the principal–agent problems in most countries around the world will be minority-versus-controlling shareholder. This means that the protection of minority rights matters most. 3.4. The diversity in group affiliation and institutional investors Many countries have large financial and industrial conglomerates and groups. In some groups, a bank or another financial institution typically lies at the apex. These can be insurance companies, as in Japan (Mørck and Nakamura, 2007), or banks, as in Germany (Fohlin, 2005). In other countries, and most often in emerging markets, a financial institution is at the center of the group. Table A2 reports that many emerging market corporations are indeed part of business groups. For example, around 20% of all Korean listed companies are members of one of the 30 largest chaebols in this country. The fraction is even higher in India and Turkey. Being part of a group can benefit firms, particularly in emerging markets, since using internal factor markets can overcome missing or incomplete external (financial) markets. Groups or conglomerates can also have costs, however, especially for investors. Worse transparency and less clear management structures provide scope for worse corporate governance, including expropriation of minority rights (Khanna and Yafeh, 2007 review; Masulis et al., 2011 present recent evidence for 45 countries). Indeed much evidence suggests that in the presence of a large divergence between cash-flow rights and voting rights, group-affiliation has detrimental effects on stock valuation (Bae et al., 2008, forthcoming; Claessens et al., 2002; Joh, 2003; Lefort, 2005) and on operating performance (Bertrand et al., 2002). Another aspect is the role of institutional investors. Studies on the role of institutional investors in corporate governance largely focus on the US (see Black, 1998; Gillan and Starks, 2003, 2007 for literature reviews). Studies are focusing nearly exclusively on voting by mutual funds and related conflict of interests (Ashraf et al., 2012; Davis and Kim, 2007) and the corporate governance of the funds themselves (Cremers et al., 2009). Ownership by institutional investors is generally small in emerging markets. With the typical dominant shareholder, institutional investors have little direct influence – through voting, board representation or otherwise – and are more concerned about protecting themselves against expropriation, rather than with disciplining management. Only a few studies examine institutional investor activism in markets with concentrated ownership and business groups. Giannetti and Laeven (2009) find some evidence of differences in voting between pension funds affiliated with business and financial groups and other pension funds in Sweden. McCahery et al. (2010) find large differences in preferences for activism between institutional investors in the U.S. and the Netherlands, countries which differ considerably in ownership structures. Yafeh and Hamdani (2011) report institutional investors in Israel to be active primarily when legally required to do so and to often fail to use the legal powers granted. But studies for emerging markets specifically are largely absent. 4. How and through what channels does corporate governance matter? We organize the literature according to how and through what channels identified corporate governance impacts corporations and countries as follows: • The first is the increased access to external financing by firms. This in turn can lead to greater investment, higher growth, and greater employment creation.

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• The second is a lowering of the cost of capital and associated higher firm valuation. This makes firms more attractive to investors, leading to growth and more employment. • The third channel is better operational performance through better allocation of resources and better management. This creates wealth more generally. • Fourth, good corporate governance can be associated with less financial crises, important, as highlighted recently again, given the large economic and social costs of crises. • Fifth channel is that good corporate governance can mean generally better relationships with all stakeholders. This helps improve social and labor relationships and aspects such as environmental protection, and can help further reduce poverty and inequality. All these channels matter for growth, employment, poverty, and well-being more generally. Empirical evidence using various techniques has documented these relationships at the level of the country, the sector, and the individual firm and from the investor perspectives. 3 4.1. Increased access to financing The role of legal foundations for financial and general development is well understood and documented (see Ang, 2008; Levine, 2005; Rathinam and Raja, 2010; Rioja and Valev, 2004). Legal foundations matter crucially for a variety of factors that lead to higher growth, including financial market development, external financing, and the quality of investment. A good legal and judicial system is also important for assuring the benefits of economic development that are shared by many. Legal foundations include property rights that are clearly defined and enforced and other key rules (disclosure, accounting, regulation and supervision). Comparative corporate governance research documenting these patterns took off following La Porta et al. (1997, 1998). These two pivotal papers emphasized the importance of law and legal enforcement for the governance of firms, development of markets, and economic growth. Numerous following studies have documented institutional differences relevant for financial markets and other aspects. 4 Many other papers have since shown the link between legal institutions and financial development (see Beck and Levine, 2005 for a review). Studies have established that the development of a country's financial markets relates to these institutional characteristics and that these characteristics can direct affect growth. Beck et al. (2000) document how the quality of a country's legal system not only influences its financial development but also has a separate, additional effect on economic growth. In a cross-country study at a sectoral level, Claessens and Laeven (2003) report that in weaker legal environments, firms not only obtain less financing but also invest less than optimal in intangible assets. The less-than-optimal financing and investment patterns in turn both affect the economic growth of a sector. Acemoglu and Johnson (2005) find that private contracting institutions play a significant role in explaining stock market capitalization. While seminal in its approach, LLSV's work and their initial indices of legal development and enforcement have been subject to a range of critical responses both on conceptual (Coffee, 1999, 2001a, 2001b; Pagano and Volpin, 2005) and measurement grounds (Lele and Siems, 2007; Spamann, 2010). Partly in response, (Djankov et al., 2008b) present a new measure of legal protection of minority shareholders: the anti-self-dealing index. Using this new measure they report that a high anti-self-dealing index is associated with higher valued stock markets, more domestic firms, more initial public offerings, and lower benefits of control. As such, the general finding that better legal protection helps with capital market development is confirmed. Nevertheless, there remain some disagreements on how important legal aspects are as drivers of financial sector development (see Armour et al., 2009). 3 Some of these studies suffer from endogeneity issues: while firms, markets, or countries may adopt better corporate governance and perform better, the relationship is not from better corporate governance to improved performance; rather it is either the other way around or because some other factors drive both better corporate governance and better performance. For discussions of the econometric problems raised by endogeneity see Himmelberg et al. (1999), Coles et al. (2012), Adams and Ferreira (2008) and Roberts and Whited (2011). 4 All these applications are important, although not novel. Coase (1937, 1960), Alchian (1965), Demsetz (1964), Cheung (1970, 1983), North (1981, 1990), and subsequent literature have long stressed how interactions between property rights and institutional arrangements shape economic behavior. La Porta et al. (1997, 1998), however, provided the tools to compare institutional frameworks across countries and study the effects in a number of dimensions, including how a country's legal framework affects firms' external financing and investment.

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This literature has shown that better creditor and shareholder rights are associated with deeper and more developed financial markets. This relationship holds across countries and over time, in that countries that improved their creditor rights saw an increase in financial development (Djankov et al., 2008b). A similar relationship exists between the quality of shareholder protection and the development of countries' capital markets. Most studies find that these results are robust to include a wide variety of control variables in the analysis. Of course, it is not just the legal rules that count, but importantly their enforcement. In this context a well staffed and independent securities regulator becomes key (Jackson and Roe, 2009). In countries with better property rights, firms thus have a greater supply of financing available, and firms invest more and grow faster (Rajan and Zingales, 1998). These effects can be large. For example, evidence suggests that countries in the third quartile of financial development enjoy between 1 and 1.5 extra percentage points of GDP growth per year, compared with countries in the first quartile. There is also evidence that under conditions of poor corporate governance (and underdeveloped financial and legal systems and higher corruption), the growth rate of the smallest firms is the most adversely affected, and fewer new firms start up—particularly small firms (Beck et al., 2005). There is also evidence on the importance of the cost of capital channel, both for equity and debt financing. Chen et al. (2011) find that U.S. firms with better corporate governance have a lower cost of equity capital after controlling for risk and other factors, with effects stronger for firms that have more severe agency problems and face greater threats from hostile takeovers. Ashbaugh-Skaife et al. (2004) report that firms with a higher degree of accounting transparency, more independent audit committees and more institutional ownership have a lower cost of capital, whereas firms with more blockholders have a higher cost. Hail and Leuz (2006) show how legal institutions affect the cost of equity. Attig et al. (2008) report for eight East Asian emerging markets that the cost of equity capital decreases in the presence of large shareholders different than the controlling owner, suggesting that second large shareholders help curb the private benefits of the controlling shareholder and reduce information asymmetries. Chen et al. (2009, 2011) find that firm-level corporate governance significantly lowers the cost of equity capital in 17 emerging markets. This effect is more pronounced in countries that provide relatively poor legal protection. Thus, in emerging markets, firm-level corporate governance and countrylevel shareholder protection seem to be substitutes for each other in reducing the cost of equity. Byun et al. (2008) show that in Korea better corporate governance practices relate negatively to estimates of implied cost of equity capital, with better shareholder rights protection having the most significant effect, followed by independent board of directors and disclosure policy. Sound governance has been shown to lower the cost of debt for US firms (Anderson et al., 2004). Lin et al. (2011) find that the cost of debt financing is significantly higher for companies with more divergence between the largest ultimate owner's control and cash-flow rights. They show that potential tunneling and other moral hazard activities by large shareholders are facilitated by their excess control rights. These activities increase the monitoring costs and the credit risks faced by banks and, in turn, raise the cost of debt. Laeven and Majnoni (2005) find that better higher judicial efficiency and enforcement of debt contracts are critical to lowering intermediation costs for a large cross-section of countries. Qian and Strahan (2007) find that stronger creditor rights result in loans with longer maturities and lower spreads. Bae and Goyal (2009) show that it is enforceability, not merely creditor rights, that matters to the cost and efficiency of loan contracting. Miller and Reisel (2012) report that bond contracts are more likely to include covenants when creditor protection laws are weak.

4.2. Higher firm valuation and better operational performance The quality of the corporate governance framework affects not only the access to and the amount of external financing, but also the cost of capital and firm valuation. Outsiders are less willing to provide financing and are more likely to charge higher rates if they are less assured that they will get an adequate rate of return. Conflicts between small and large controlling shareholders – arising from a divergence between cash-flow and voting rights – are greater in weaker corporate governance settings, implying that smaller investors are receiving too little of the returns the firm makes. Better corporate governance can also add value by improving firm performance, through more efficient management, better asset allocation, better labor policies, and other efficiency improvements.

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There is convincing empirical evidence for these effects. Table A3 gives an overview of empirical analyses of the relationship between ownership structures and company valuations and operational performance. Firm value, typically measured by Tobin's q, the ratio of market to book value of assets, is higher when the largest owner's equity stake is larger, but lower when the wedge between the largest owner's control and equity stake is larger (Claessens et al., 2002; Lins, 2003; Mitton, 2002). Large non-management control rights, blockholdings, are also positively related to firm value. These effects are more pronounced in countries with low legal shareholder protection (Pursey et al., 2009). Much evidence from individual countries such as Korea (Bae et al., forthcoming), Hong Kong (Lei and Song, 2008), Brazil, Chile, Colombia, Peru and Venezuela (Cueto, 2008) confirms that less deviation between cash flow and voting rights is positively associated with relative firm valuation. This effect is substantial: a one standard deviation decrease in the degree of divergence is associated with an increase in Tobin's q of 28% (an increase in stock price of 58%) in Chile. Similar effects are reported for Korea (Black et al., 2006) and Turkey (Yurtoglu, 2000, 2003). The country and firm level studies suggest that better corporate governance improves market valuations. Two forces are at work here. First, better governance practices can be expected to improve the efficiency of firms' investment decisions, thus improve the companies' future cash flows which can be distributed to shareholders. The second channel works through a reduction of the cost of capital which is used to discount the expected cash flows. Better corporate governance reduces agency risk and the likelihood of minority shareholders' expropriation and possibly leads to higher dividends, making minority rights shareholders more willing to provide external financing. While fewer studies analyze operating performance than valuation, the ones that do, report in general positive effects when agency issues are less. Wurgler (2000) shows the general beneficial role well developed financial markets play in the allocation of capital. In a cross-country empirical study, Claessens et al. (2010) show that the responses of investment to changes in Tobin's q are faster in countries with better corporate governance and information systems. A positive impact of foreign corporate ownership on operating performance is documented by Douma et al. (2006) for India. Pant and Pattanayak (2007) find that inside owners in India improve operating performance when ownership is smaller than 20% and greater than 49%, suggesting entrenchment effects at intermediate levels. For Taiwan, insider ownership is negatively and institutional ownership positively related to total factor productivity. Similarly for Taiwan, Yeh et al. (2001) find adverse effects of entrenched owners. Filatotchev et al. (2005) document a positive impact of institutional investors and foreign financial institutions ownership on performance. Orbay and Yurtoglu (2006) report a negative influence of the ownership-control disparity on investment performance in Turkey. Wiwattanakantang (2001) reports that controlling shareholders' involvement in management negatively affects performance in Thailand. Carvalhal da Silva and Leal (2006) for Brazil and Gutiérrez and Pombo (2007) for Colombia report higher operating performance where owners have more cash flow rights and no ownership disparity. Besides financial and capital markets, other factor markets need to function well to prevent corporate governance problems. These real factor markets include all output and input markets, including labor, raw materials, intermediate products, energy, and distribution services. Firms subject to more discipline in the real factor markets are more likely to adjust their operations and management to maximize value added. Corporate governance problems are therefore less severe when competition is already high in real factor markets. The importance of competition for good corporate governance is true in financial markets as well. The ability of insiders, for example, to mistreat minority shareholders consistently can depend both on the degree of competition and protection. If small shareholders have little alternative but to invest in lowearning assets, for example, controlling shareholders may be more able to provide a below-market return on minority equity. 5 Open financial markets can thus help improve with corporate governance, one of the so-called collateral benefits of financial globalization (Kose et al., 2010). 5 The role of competition in financial development and stability is, however, still being debated (see the views of Thorsten Beck versus those of Franklin Allen in one of The Economist debates in June 2011). Theoretically, less competition can be preferable in a second-best world if banks expand lending under stronger monopoly rights and thereby enhance overall output (Hellmann et al., 2000). Less competition may also lead to more financial stability as financial institutions have greater franchise value and act therefore more conservative. On the other hand, competition leads to more pressures to reduce inefficiencies and lower costs, and can stimulate innovation. Besides the beneficial effects of reducing inefficiencies or weeding out corrupt lending practices often associated with protected financial systems, greater competition may also reduce excessive risk taking (Boyd and Nicoló, 2005) and promote (implicit) investment coordination among firms (Abiad et al., 2008).

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Surprisingly, while well accepted and generally acknowledged (see Khemani and Leechor, 2001), there is less empirical evidence on the role of competition in relationship to corporate governance. Guadalupe and Perez-Gonzalez (2010) show that within-country increases in the intensity of competition lead to a reduction in the level and dispersion of private benefits of control. Their results are more pronounced in weak-rule-of-law countries. In a paper on Poland, Grosfeld and Tressel (2002) find that competition has a positive effect on firms with good corporate governance, but no significant effects on firms with bad corporate governance. Li and Niu (2007) find that moderate concentrated ownership and product market competition are complementary in enhancing the performance of Chinese listed firms. They also report that competitive pressures can substitute for weak board governance. Bhaumik and Piesse (2004) observe patterns of change in technical efficiency from 1995 to 2001 for Indian banks consistent with the notion that competitive forces are more important than ownership effects. Estrin (2002) documents that weak competitive pressures played a pivotal role in the poor evolution of corporate governance in transition countries. Conversely, Estrin and Angelucci (2003) find evidence that post-transition competitive pressures encouraged better managerial actions, including deep restructuring and investment. 4.3. Less volatile stock prices The quality of corporate governance can also affect firms' behavior in times of economic shocks and actually contribute to the occurrence of financial distress, with economy-wide impacts. During the East Asian financial crisis, cumulative stock returns of firms in which managers had high levels of control rights, but little direct ownership, were 10 to 20 percentage points lower than those of other firms (Lemmon and Lins, 2003). This shows that corporate governance can play an important role in determining individual firms' behavior, in particular the incentives of insiders to expropriate minority shareholders during times of distress. Similarly, a study of the stock performance of listed companies from Indonesia, Korea, Malaysia, the Philippines, and Thailand found that performance is better in firms with higher accounting disclosure quality (proxied by the use of Big Six auditors) and higher outside ownership concentration (Mitton, 2002). This provides firm-level evidence consistent with the view that corporate governance helps explain firm performance during a crisis. Related work shows that hedging by firms is less common in countries with weak corporate governance frameworks (Lel, 2012), and to the extent that it happens, it adds very little value (Allayannis et al., 2009). The latter evidence suggests that in these environments, hedging is not necessarily for the benefit of outsiders, but more for the insiders. There is also evidence that stock returns in emerging markets tend to be more positively skewed than in industrial countries (Bae et al., 2006). This can be attributed to managers having more discretion in emerging markets to release information, disclosing good news immediately, while releasing bad news slowly, or that firms share risks in these markets among each other, rather than through financial markets. There is also country-level evidence that weak legal institutions for corporate governance were key factors in exacerbating the stock market declines during the 1997 East Asian crisis (Johnson et al., 2000). In countries with weaker investor protection, net capital inflows were more sensitive to negative events that adversely affect investors' confidence. In such countries, the risk of expropriation increases during bad times, as the expected return of investment is lower, and collapses in currency and stock prices are more likely. The view that poor corporate governance of individual firms can have economy-wide effects is not limited to developing countries. In the early 2000s, the argument was made that in developed countries corporate collapses (like Enron), undue profit boosting (by Worldcom), managerial corporate looting (by Tyco), audit fraud (by Arthur Andersen), and inflated reports of stock performance (by supposedly independent investment analysts) led to crises of confidence among investors, leading to the declines in stock market valuation and other economy-wide effects, including some slowdowns in economic growth. Evidence from financial crises suggests as well that weaknesses in corporate governance of financial and non-financial institutions can affect stock return distributions. Consistently, Bae et al. (forthcoming) find that during the 1997 Asian financial crisis, firms with weaker corporate governance experience a larger drop in their share values, but during the post-crisis recovery period, such firms experience a larger rebound in their share values. And during the recent financial crisis, firms that had better internal corporate governance tend to have higher rates of return (Cornett et al., 2009). Importantly, in the recent financial crisis, corporate

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governance failures at major financial institutions, such as Lehman and AIG, contributed to the global financial turmoil and subsequent recessions. While this is more anecdotal evidence, it is clear that corporate governance deficiencies can carry a discount, either specific to particular firms or for markets as whole, in developed as well as developing countries, and even lead to financial crises. As such, poor corporate governance practices can pose a negative externality on the economy as a whole. 4.4. Better functioning financial markets and greater cross-border investments More generally, poor corporate governance can affect the functioning of a country's financial markets and the volume of cross-border financing. One channel is that poor corporate governance can increase financial volatility. When information is poorly protected – due to a lack of transparency and insiders having an edge on firms' doing and prospects – investors and analysts may have neither the ability to analyze firms (because it is very costly to collect information) nor the incentive (because insiders benefit regardless). In such a weak property rights environment, inside investors with private information, including analysts, may, for example, trade on information before it is disclosed to the public. There is evidence that the worse transparency associated with weaker corporate governance leads to more synchronous stock price movements, limiting the price discovery role of stock markets (Mørck et al., 2000). A study of stock prices within a common trading mechanism and currency (the Hong Kong stock exchange) found that stocks from environments with less investor protection (China-based) trade at higher bid-ask spreads and exhibit thinner depths than more protected stocks (Hong Kong-based) (Brockman and Chung, 2003). Evidence for Canada suggests that ownership structures indicating potential corporate governance problems also affect the size of the bid-ask spreads (Attig et al., 2006). This behavior imparts a degree of positive skewness to stock returns, making stock markets in well-governed countries better processors of economic information than are stock markets in poorly governed countries. Another area where corporate governance affects firms and their valuation is mergers and acquisitions (M&A). Indeed, during the last two decades, the volume of M&A activity and the premium paid were significantly larger in countries with better investor protection (Rossi and Volpin, 2004). This indicates that an active market for mergers and acquisitions – an important component of a corporate governance regime – arises only in countries with better investor protection. Also, in cross-border deals, the acquirers are typically from countries with better investor protection than the targets, suggesting cross-border transactions play a governance role by improving the degree of investor protection within target firms and aiding in the convergence of corporate governance systems. A recent study by Bhagat et al. (2011) reports that emerging country acquirers experience a significantly positive market response of 1.09% on the announcement day. These abnormal returns are positively correlated with (better) corporate governance measures in the target country. Starks and Wei (2004) and Bris and Cabolis (2008) also report a higher takeover premium when investor protection in the acquirer's country is stronger than in the target's country. And Ferreira et al. (2010) show that foreign institutional ownership significantly increases the probability that a local firm will be targeted by a foreign bidder, with effects economically significant: a 10 percentage point increase in foreign ownership doubles the fraction of cross-border M&As (relative to the total number of M&As in a country). It also suggests that foreign portfolio investments and cross-border M&As are complementary mechanisms in promoting corporate governance worldwide. 4.5. Better relations with other stakeholders Besides the principal owner and management, public and private corporations must deal with many other stakeholders, including banks, bondholders, labor, and local and national governments. Each of these monitor, discipline, motivate, and affect the management and the firm in various ways. They do so in exchange for some control and cash flow rights, which relate to each stakeholders' own comparative advantage, legal forms of influence, and form of contracts. Commercial banks, for example, have a greater amount of inside knowledge, as they typically have a continued relationship with the firm. Formal influence of commercial banks may derive from the covenants banks impose on the firm: for example, in terms of dividend policies, or requirements for approval of large investments, mergers and acquisitions, and other large undertakings. Bondholders may also have such covenants or even specific collateral.

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Furthermore, lenders have legal rights of a state-contingent nature. In case of financial distress, they acquire control rights and even ownership rights in case of bankruptcy, as defined by the country's laws. 6 Debt and debt structure can be important disciplining factors, as they can limit free cash flow and thereby reduce private benefits. Trade finance can have a special role, as it will be a short-maturity claim, with perhaps some specific collateral. Suppliers can have particular insights into the operation of the firm, as they are more aware of the economic and financial prospects of the industry. Labor has a number of rights and claims as well. As with other input factors, there is an outside market for employees, thus putting pressure on firms to provide not only financially attractive opportunities, but also socially attractive ones. Labor laws define many of the relationships between corporations and labor, which may have some corporate governance aspects. Rights of employees in firm affairs can be formally defined, as is the case in Germany, France, and the Netherlands where in larger companies it is mandatory for labor to have some seats on the board (the co-determination model). 7 Employees of course voice their opinion on firm management more generally. And then there is a market for senior management, where poorly performing CEOs and other senior managers get fired or good performing managers leave weakly performing corporations, that exerts some discipline on poor performance. It is hard to give a definitive answer as to whether and which forms of stakeholders' involvement are good for a corporation as a whole, let alone whether they are socially and economically optimal. There are many aspects of stakeholders' involvement, with various consequences – for firm performance, value added, risk taking, environmental performance, etc. – and the overall net benefits are often unclear given current state of research. While, like for other aspects of corporate governance, some many studies increasingly often can clearly imply causality (as they use specific econometric techniques or study some event that exogenously changes the institutional environment), some papers report only associations. What can be distinguished are two forms of behavior related to other stakeholders' role in corporate governance issues: stakeholder management and social issue participation.

4.5.1. Stakeholder management For the first category, the firm has no choice but to behave “responsibly” to stakeholders: they are input factors without which the firm cannot operate; and these stakeholders face alternative opportunities if the firm does not treat them well (typically, for example, labor can work elsewhere). Better employment protection can then improve the incentive structure and relative bargaining power of employees, and lead to more output. Acting responsibly toward each of these stakeholders is thus necessary. Acting responsibly is also most likely to be beneficial to the firm, financially and otherwise. Acting responsibly towards other stakeholders might in turn also be beneficial for the firm's shareholders and other financial claimants. A firm with a good relationship with its workers, for example, will probably find it easier to attract external financing. Bae et al. (2011) report that U.S. firms that treat their employees more fairly maintain lower debt ratios, i.e., are less risky financed, in part since employees want to preserve their job. This suggests that inside stakeholders can affect a firm's financial policies. Collectively, a high degree of corporate responsibility can ensure good relationships with all the firm's stakeholders and thereby improve the firm's overall performance. Of course, the effects depend importantly on information and reputation because knowing which firms are more responsible to stakeholders will not always be easy. Ratings at a country level, such as a ranking of the “best firms to work for,” can help in this respect.

6 Countries differ in this respect. In the United States, for example, banks are limited in intervening in corporations operations, as they can be deemed to be acting in the role of a shareholder, and therefore assume the position of a junior claimholder in case of a bankruptcy (the doctrine of equitable subordination). This greatly limits U.S. banks' incentives to get involved in corporate governance issues as it may lead to their claim being lowered in credit standing. Other countries allow banks a greater role in corporate governance. 7 Employee ownership is of course the most direct form in which labor can have a stake in a firm. The empirical evidence on the effects of employee ownership for U.S. firms is summarized by Kruse and Blasi (1995). They find that “while few studies individually find clear links between employee ownership and firm performance, meta-analyses favor an overall positive association with performance for ESOPs and for several cooperative features”. A more recent study by Faleye et al. (2009) finds that labor-controlled publicly-traded firms “deviate more from value maximization, invest less in long-term assets, take fewer risks, grow more slowly, create fewer new jobs, and exhibit lower labor and total factor productivity”.

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4.5.2. Social issue participation Recent years have witnessed a growing interest in corporate social responsibility (CSR) both from academia (Margolis and Walsh, 2003; McWilliams and Siegel, 2001; Orlitzky et al., 2003) and from businesses (see Accenture, 2010). This greater emphasis placed by firms on CSR activities can be interpreted as a shift in the interaction between firms, their institutional environment, and important stakeholders, such as communities, employees, suppliers, national governments and broader societal issues (Ioannou and Serafeim, 2010). In spite of this greater involvement, whether participation in social issues also relates to good firm performance is less clear. Involvement in some social issues carries costs. These can be direct, as when expenditures for charitable donations or environmental protection increase, and so lower profits. Costs can also be indirect, as when the firm becomes less flexible and operates at lower efficiency. As such, socially responsible behavior could be considered “bad” corporate governance, as it negatively affects performance. (Of course, it can also be the case that government regulations require certain behavior, such as safeguarding the environment, such that the firm has no choice—although the country does. These are not considered here.) The general argument has been that many of these forms of social corporate responsibility can still pay: that is, they can be good business for all and go hand in hand with good corporate governance. So while there may be less direct business reasons to respect the environment or donate to social charity, such actions can still create positive externalities in the form of better relationships with other stakeholders, signaling the value of products to buyers, or being seen as good citizens. The willingness, for example, of many firms to adopt high international standards, such as ISO 9000, that clearly go beyond the narrow interest of production and sales, suggests that there is empirical support for positive effects at the firm level. The general empirical findings are of mixed evidence or no relationship between corporate social responsibility and financial performance. As with many other corporate governance studies, the problem is in part the endogeneity of the relationships. At the firm level, does good corporate performance beget better social corporate responsibility, as the firm can afford it? Or does better social corporate responsibility lead to better performance? The firms that adopt ISO standards, for example, might well be the better performing firms even if they had not adopted such standards. At the country level, a higher level of development may well allow and create pressures for better social responsibility, while also improving governance. So far, there have been few formal empirical studies at the firm level to document these effects. Empirically, it is extremely difficult to find satisfactory proxies of corporate social performance (CSP). Consequently, existing indicators show a great deal of variation and tend to capture either a single specific dimension or very broad measures of CSP. A recent study (Ioannou and Serafeim, 2010) uses a unique dataset from ASSET4 (Thompson Reuters), which covers 2248 publicly listed firms in 42 countries for the period 2002 to 2008 and ranks firms along three dimensions: social, environmental and corporate governance performance. It reports a significant variation in CSP across countries and a negative association between insider ownership and social and environmental performance at the firm level. This suggests that better corporate governance is associated with better CSP, even though the direction and causal nature of the link is not established. Clearly, more developed countries tend to have both better corporate governance and rules requiring more socially responsible behavior of corporations. These stronger rules can pay off in terms of firm performance if they induce stakeholders to contribute more to the firm. There is some evidence for this. Claessens and Ueda (2011) find that greater employment protection in US states promotes knowledgeintensive industries as it induces workers to make firm-specific human capital investments and thereby boosts overall output. There is some evidence, however, that government-forced forms of stakeholdership may be less advantageous financially. In the case of Germany, one study found that workers' codetermination reduced market-to-book values and return on equity (Gorton and Schmid, 2000). And Kim and Ouimet (2008), investigating the effects of employee ownership plans in the U.S., find that small employment share ownership increases firm value, but not when larger than 5% of outstanding shares. And there is ample evidence that too strong labor regulations hinder economic growth. In a cross-country analysis, Botero et al. (2004) show that heavier labor regulation is associated with lower labor force participation and higher unemployment. Other cross-country regressions also generally find such negative effects (e.g., Cingano et al., 2009). Overall, the effect of institutions on corporate social responsibility appears to be larger than the effect at the industry and firm level. Political institutions (the absence of corruption) in a country and the

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prominence of a leftist ideology, are the most important determinants of social and environmental performance. Legal institutions, such as laws that promote business competition, and labor market institutions, such as labor union density and availability of skilled capital are also important determinants. Capital market institutions do not seem to play an important role (Chapple and Moon, 2005; Ioannou and Serafeim, 2010). 5. Corporate governance reform The analysis so far suggests that better corporate governance generally pays for firms, markets, and countries. The question then arises why firms, markets, and countries do not adjust and adopt voluntarily better corporate governance measures. The answer is that firms, markets, and countries do adjust to some extent, but that these steps fail to provide the full impact, work only imperfectly, and involve considerable costs. And there is often little progress and sometimes it takes a major crisis to get reforms going. The main reasons for lack of sufficient reforms are entrenched owners and managers at the level of firms and political economy factors at the level of markets and countries. We start by documenting examples of important corporate governance reforms and their effects. We then examine the various voluntary mechanisms of governance adopted by firms. We end with a review of the political economy factors for lack of sufficient reform. 5.1. Recent country level reforms and their impact In the last decade, many emerging markets have reformed parts of their corporate governance systems. Many of these changes have occurred in the aftermath and as a response to crises (Black et al., 2001). While some reforms have been major and introduced fundamental changes in capital market laws and regulations (e.g., Korea), others were more partial and changed only a few specific aspects (e.g., Turkey). Many countries, for example, have adopted corporate governance codes to which firms voluntary can adhere. Nevertheless, these reforms can be useful ways to identify the importance of corporate governance. Indeed researchers have analyzed the specific features of these reforms and other actions to quantify their impact on firm level performance measures (see Table A4 for an overview of studies). 5.1.1. Legal reforms Korea has been much studied as it has undertaken dramatic reforms in the aftermath of the crisis. Nontransparent management and excessive expansion of Korean firms were important reasons for the crisis (World Bank, 2000) and the government consequently adopted a series of major reforms targeting internal and external control mechanisms (World Bank, 2006). First, the role of the board of directors was strengthened by introducing a mandatory quota for outsiders, starting in 1999, at least one-quarter of the board members for listed companies required to be independent outsiders. Since outside directors were uncommon prior to 1997, post-crisis Korea presents a natural laboratory for testing the effect of board independence enforced by authorities. Other policies aimed to weaken the ties among group-affiliated firms through the elimination of cross-debt guarantees, restrictions on intra-group transactions, elimination of restrictions on foreign ownership, and removal of restrictions on exercising voting rights by institutional shareholders. These reforms triggered restructuring activities by Korean firms (Park and Kim, 2008), with important effects on valuation and operating performance (Choi et al., 2007). Black and Kim (2012) report a positive share price impact of boards with 50% or greater outside directors, and some evidence of a positive impact from the creation of an audit committee. For board composition, value increases exist for firms which are either required by law to have 50% outside directors or voluntarily adopt this practice. Similar analyses exist for other countries. Black and Khanna (2007) analyze a major governance reform in India in 2000, Clause 49, which resembles the U.S. Sarbanes Oxley Act. It requires, among other things, audit committees, a minimum number of independent directors, and CEO/CFO certification of financial statements and internal controls. The reforms applied initially only to larger firms, and reached smaller public firms after a several-year lag. They document that this reform benefited firms that need external equity capital and cross-listed firms more, suggesting that local regulation can complement, rather than substitute for firmlevel governance practices.

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A similar positive impact from improvements in the regulatory regime is documented by Beltratti and Bortolotti (2007) and Li et al. (2011) in China. Non tradable shares (NTS) were long recognized by investors as one of the major hurdle to corporate governance. During 2005–2006, Chinese regulators eliminated, through a decentralized process, NTS in the capital of listed firms. The market responded very positive to this. After more than doubling in value over the period, the market rose another 40% in the first four months of 2007, immediately after the completion of the reform. Another reform in China was the introduction of mandatory cumulative voting in director elections in January 2002. Qian and Zhao (2011) show that firms with cumulative voting experienced less expropriation and improved investment efficiency and performance relative to other firms. Another example is the change in the Bulgarian Securities Law in 2002 which provided protection against dilutive offerings and freeze-outs. Atanasov et al. (2006) document that following the change, share prices jumped for firms at high risk of tunneling, relative to a low-risk control group. Minority shareholders participated equally in secondary equity offers, whereas before they suffered severe dilution, and freeze-out offer prices quadrupled. For Israel, Lauterbach and Yafeh (2011) study the effects of a regulatory change that induced the unification of most dual class shares in the 1990s. They find that the legal change had a minor effect both on the ownership structures of firms and their performance and valuation. Also using data from Israel, Yafeh and Hamdani (2011) find that legal intervention can play an important role in inducing institutional investor activism. 5.1.2. Corporate governance codes and convergence In recent years, a large number of countries have issued corporate governance codes to which corporations can adhere voluntarily (Guillén, 2000; Nestor and Thompson, 2000). Globalization and the worldwide integration of financial markets, combined with limited local legal reforms, are acting as main drivers of this process (Khanna et al., 2006). Indeed, Aguilera and Cuervo-Cazurra (2004) show that corporate governance codes more likely emerge in more liberalized countries with a strong presence of foreign institutional investors as well as in countries with weak legal protections and that civil law countries less often revise and update their codes. As part of a worldwide convergence of corporate governance standards, an important question is whether these codes, and the integration of product and financial markets more generally, help with convergence in actual corporate governance practices or just lead to formal convergence. 8 The evidence to date suggests more the latter. Several authors argue that strong path dependence will prevent the convergence of corporate governance systems (Bebchuk and Hamdani, 2009; Bebchuk and Roe, 1999; Coffee, 1999; Gilson, 2001).9 In a survey article, Yoshikawa and Rasheed (2009) show that there is only limited evidence of convergence of systems to date, with convergence more observed in form than in substance. They also suggest that convergence, where it occurs, is often contingent on other factors, such as the country's institutional and political environment. Using a sample of corporations from various countries, Khanna et al. (2006) similarly report evidence of formal convergence at the country level, but find actual corporate governance practices to remain heterogeneous. This brings us to the role of firm-level corporate governance practices. 5.1.3. The role of firm-level voluntary corporate governance actions Evidence shows that firms can and do adapt to weaker environments by adopting voluntary corporate governance measures. A firm may adjust its ownership structure, for example, by having more secondary, 8 Gilson (2001) differentiates between three kinds of convergence: functional convergence, when existing institutions are flexible enough to respond to the demands of changed circumstances without altering the institutions' formal characteristics; formal convergence, when an effective response requires legislative action to alter the basic structure of existing institutions; and contractual convergence, where the response takes the form of contract because existing institutions lack the flexibility to respond without formal change, and political barriers restrict the capacity for formal institutional change. 9 Bebchuk and Roe (1999) identify two causes for this path dependence: structure-driven and rule-driven path dependence. Structure-driven path dependence can arise either because an organization has adapted to a particular ownership structure and thus would sacrifice efficiency by changing, or because certain stakeholders – like the managers or the dominant shareholder – would lose from a shift to a more efficient structure, and thus resist such a change. Rule-driven path dependence can arise for similar reasons. A country may adopt laws and regulations that are designed to make companies with the existing ownership structures most efficient, and/or influential managers and shareholders may be able to induce the political system to maintain a set of rules, which, although inefficient, is to their advantage.

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large blockholders, which can serve as effective monitors of the primary controlling shareholders. This may convince minority shareholders of the firm's willingness to respect their rights. Or a firm may adjust its dividend behavior to convince shareholders that it will reinvest properly and for their benefit. Voluntary mechanisms can also include hiring more reputable auditors. Since auditors have some reputation at stake as well, they may agree to conduct an audit only if the firm itself is making sufficient efforts to enhance its own corporate governance. The more reputable the auditor, the more the firm needs to adjust its own corporate governance. A firm can also issue capital abroad or list abroad, thereby subjecting itself to higher level of corporate governance and disclosure. Empirical evidence shows that these mechanisms can add value and are appreciated by investors in a variety of countries. At the same time, the country's legal and enforcement environment can still reduce their effectiveness. We review each of these mechanisms. 5.1.4. Voluntary adoption of corporate governance practices In the last decade, many researchers have linked actual corporate governance practices of firms to their market valuation and performance. Typically, such studies score firms on their corporate governance practices using indices based on shareholder rights, board structure, board procedures, disclosure, and ownership parity. Early studies were mostly for advanced countries and within a single country, not allowing for studying differences in legal and enforcement regimes. An influential study of a sample of U.S. firms found that the more firms adopt voluntary corporate governance mechanisms, the higher their valuation and the lower their cost of capital (Gompers et al., 2003). Similar evidence exists for the top 300 European firms (Bauer et al., 2004).10 Other studies (see Table A5 for a summary of key studies) generally showed as well that improved firm corporate governance practices increase firm share prices, hence, better-governed firms appear to enjoy a lower cost of capital. The improvement in valuation derives from several channels. Evidence for the United States (Gompers et al., 2003), Korea (Joh, 2003), and elsewhere strongly suggests that at the firm level, better corporate governance leads not only to improved rates of return on equity and higher valuation, but also to higher profits and sales growth, and lower capital expenditures and acquisitions to levels that are presumably more efficient. This evidence is maintained when controlling for the fact that “better” firms may adopt better corporate governance and perform better due to other reasons. Across countries, there is also evidence that operational performance is higher in better governance countries, although the evidence is less strong. The magnitude of the effects can be quite substantial. For example, Black et al. (2006) report that a worst-to-best change in their corporate governance index for Korean firms predicts a 0.47 increase in their Tobin's q, which corresponds to an almost 160% increase in the share price. Black et al. (forthcoming) and Braga-Alves and Shastri (2011) report similar results for Brazil. Comparing effects in India, Korea, and Russia, they find that different practices are important in different countries for different types of companies. Country characteristics thus influence which aspects affect market value for which firms. There is some evidence that voluntary practices matter more in weak environments. Two studies (Durnev and Kim, 2005; Klapper and Love, 2004) find that firm-level practices matters more to firm value in countries with weaker investor protection. Other studies suggest that legal regimes can also be too strict. Bruno and Claessens (2010a) find that adopting specific practices improves firm valuation in both weak and strong legal protection countries. The impact varies, however, by countries' legal system, with practices impacting valuation less in strong legal regimes, suggesting that strong legal regimes may not necessarily be optimal. This again supports a flexible approach to governance, with room for firm choice, rather than a top-down regulatory approach (see further Bruno and Claessens, 2010b). Markets can adapt as well, partly in response to competition, for example as listing and trading migrate to competing exchanges. While there can be races to the bottom, with firms and markets seeking lower standards, markets can and will set their own, higher corporate governance standards. One example is the Novo Mercado in Brazil, which has different levels of corporate governance standards, all higher than the main stock exchange. Firms can choose the level they want, and the system is backed by private arbitration measures to settle corporate governance disputes. Efforts like these have been shown to corporations improve corporate governance at low(er) costs as they can list locally (Carvalho and Pennacchi, forthcoming). 10 For the top 300 European firms, it was found that a strategy of over-weighting companies with good corporate governance and under-weighting those with bad corporate governance would have yielded an annual excess return of 2.97% (Bauer et al., 2004).

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Other papers report how private contracting can mitigate the costs of weak legal protection of investors. Carvalhal da Silva and Subrahmanyam (2007) show that the effect of the mandatory bid rule on the dual-class premium is moderated by the rules that companies voluntarily grant to their minority shareholders. Bennedsen et al. (2011) report that voluntarily granted tag-along rights substitute an equal price provision in the takeover legislation. There is evidence, however, that these alternative corporate governance mechanisms, apart from being costly, have their limits. In a context of weak institutions and poor property rights, firm measures cannot and do not fully compensate for deficiencies. The work of Klapper and Love (2004), Durnev and Kim (2005) and Doidge et al. (2007) shows that voluntary corporate governance adopted by firms only partially compensates for weak governance environments. 5.1.5. Boards Boards constitute an important governance mechanism. Several studies find a strong connection between board composition and market valuations of emerging market companies (Table A6 provides an overview of studies). While some studies suffer from endogeneity problems, in that better firms are more likely to adopt more independent boards, other can control for this problem, by looking at how reforms affected firms differentially. Findings suggest that companies with boards comprised of a higher fraction of outsider/independent directors usually have a higher valuation. Black et al. (2006) report that Korean firms with 50% outside directors have 0.13 higher Tobin's q (roughly 40% higher share price). Some evidence also shows that stronger board structures reduce the likelihood of fraud (Chen et al., 2006) and expropriation through related party transactions (Lo et al., 2010). The positive effects of board independence documented for Korea and India are in countries where governance reforms mandate a substantial level of board independence. Boards appear ineffective or even hurt minority shareholders in countries (e.g., Turkey), where some arbitrarily low level of board independence is recommended by existing codes of governance (Ararat et al., 2011). Overall, results suggest that board independence plays an important role in developing countries and emerging markets as well, where other control mechanisms on insiders' self-dealing are weaker. There is also some evidence that board independence has to reach a certain threshold and be mandated to be effective. 5.1.6. Cross-listings Firms that have access to foreign capital markets are more likely to obtain capital at more favorable terms, so that they have greater incentives to adopt good governance (Stulz, 1999). Correspondingly, Doidge et al. (2007) argue that financial globalization should reduce the importance of the countryspecific determinants of governance and increase firm-level incentives for good governance. Indeed, there is some evidence that globalization has improved corporate governance (Stulz, 2005). Cross-listing securities on foreign markets is a specific way to access international financial markets and can relate and affect firms' corporate governance practices. There are several reasons why companies may decide to cross-list. One argument is that firms can get cheaper external financing (Karolyi, 1998). More recent studies consider, however, various other motives for cross-listings (see Table A7 for an overview and Karolyi (2012) for a literature review). One corporate governance motive is that by crosslisting in a stronger environment, firms commit to tough disclosure and corporate governance rules. This has been called the “bonding” argument (Coffee, 1999, 2001a, 2001b). This view, also in Doidge et al. (2004), has been analyzed by Doidge et al. (2009). They find support since controlling shareholders who consume more private benefits of control are more reluctant to crosslist their firms on a U.S. exchange, despite the financial benefits of a cross-listing. Silvers and Elgers (2010) also report that legal bonding plays a significant role in increasing the value of non-U.S. firms. Gande and Miller (2011) provide evidence that enforcement actions of U.S. securities regulators against foreign firms are quite frequent and economically significant events which support the bonding view since the enforcement of U.S. securities laws is a necessary condition for the bonding hypothesis to hold. Three country-specific studies (Chung et al., 2011; Licht, 2001; Siegel, 2005; for a review see Licht, 2003) challenge the bonding argument, however, by showing that firms are more likely to choose crosslisting destinations that are less strict on self-dealing or exhibit higher block premiums relative to the origin country, with this tendency more pronounced after Sarbanes–Oxley in 2002. Other studies also point out that the ability of corporations to borrow the framework from other jurisdictions by listing or

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raising capital abroad, or even incorporating, is limited to the extent that some local enforcement of rules is needed, particularly concerning minority rights protection (see Siegel (2009) for the case of Mexico). There is also some evidence on the impact of cross-listings by means of ADR programs for companies from emerging markets. Karolyi (2004) and Levine and Schmukler (2006) show that such programs are associated with more cross-border flows and greater integration with world capital markets, but also have a harmful effect on domestic stock market development measured by the number of listed firms, their overall capitalization and trading activity in the home market. The findings are consistent with the argument that cross-listings signal that a firm is of comparatively high quality (Blass and Yafeh, 2001), which might then have adverse implications on the liquidity of domestic firms. As such, there remains considerable debate on the corporate governance motivations for and benefits of cross-listing. 5.1.7. Other mechanisms The decision to adopt IAS (International Accounting Standards) enables firms to provide financial information in a more familiar and more reliable form to investors. This should reduce information asymmetries and help with signaling to shareholders the willingness of the firm to adhere to sound corporate governance practices, thus make the firms more attractive to invest in. Covrig et al. (2007) analyze firm-level holdings of over 25,000 mutual funds from around the world and find that average foreign mutual fund ownership is significantly higher among IAS adopters. IAS adopters attract not only a significantly larger pool of investors by reducing foreign investors' information processing and acquisition costs, but, as Chan et al. (2009) show, achieve a lower the cost of capital as well. In line with this mechanism, Fan and Wong (2005) show that hiring high-quality reputable external independent auditors enhances the credibility of the dominant shareholders with investors. They find that East Asian firms subject to greater agency problems, indicated by high control concentration, are more likely to hire Big 5 auditors than firms less subject to agency problems. This relation is especially evident among firms frequently raising equity capital in secondary markets. Additionally, hiring Big 5 auditors mitigates the share price discounts associated with their agency problems. The reforms and the voluntary corporate governance practices have led to many de facto changes in corporate governance. These actual changes and their effects are analyzed by De Nicolo et al. (2008). Using actual outcome variables in the dimensions of accounting disclosure, transparency, and stock price behavior, they construct a composite index of corporate governance quality at the firm level, document its evolution for many corporations around the world during the 1994–2003 period, and assess its impact on growth and productivity of the economy and its corporate sector. They report three main findings. First, actual corporate governance quality in most countries has overall improved, although in varying degrees and with a few notable exceptions. Second, the data exhibit cross-country convergence in corporate governance quality with countries that score poorly initially catching up with countries with high corporate governance scores. Third, the impact of improvements in corporate governance quality on traditional measures of real economic activity – GDP growth, productivity growth, and the ratio of investment to GDP – is positive, significant and quantitatively relevant, and the growth effect is particularly pronounced for industries that are most dependent on external finance. 5.1.8. The role of political economy factors Countries do not always reform their corporate governance frameworks to achieve the best possible outcomes. In some sense, this is shown by the pervasive and continued importance of the origin of the legal system in a particular country in many analyses and dimensions. Whether a country started with or acquired as a result of colonization a certain legal system some century or more ago still has systematic impact on the features of its legal system today, the performance of its judicial system, the regulation of labor markets, entry by new firms, the development of its financial sector, state ownership, and other important characteristics (Acemoglu et al., 2001; Djankov et al., 2008b). Evidently, countries do not adjust that easily and move to some better standards to fit their own circumstances and meet their own needs. Partly this is because reforms are multifaceted and require a mixture of legal, regulatory, and market measures, making for difficult and slow progress. Efforts may have to be coordinated among many constituents, including foreign parties. Legal and regulatory changes must take into account enforcement capacity, often a binding constraint. While financial markets face competition and can adapt themselves, they must operate within the limits given by a country's legal framework. The Nova Mercado in Brazil is a notable

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exception where the local market has improved corporate governance standards using voluntary mechanisms, with much success in terms of new listing and increases in firm valuation (Carvalho and Pennacchi, forthcoming). But it needs to rely on mechanisms such as arbitration to settle corporate governance disputes as an alternative to the poorly functioning judicial system in Brazil. Other experiments with self-regulation in corporate governance, as in the Netherlands, have often not been successful.11 More generally, the move towards greater public oversight and tighter regulation in advanced and other countries following the recent financial crisis is a reflection of the limits to the effectiveness of the previous prevailing model of more self-regulation and supervision. So why do countries not reform their institutional systems? Part of the reason lies in the values and rents political and other insiders get from the status quo. Studies which try to quantify the value of political connections show that the size of these rents can reach substantial amounts (see Table A8 for an overview of this literature). For example, in Indonesia, there were direct relationships between the government and the corporate sector. Fisman (2001) estimates the value of political connections to the Suharto regime, using announcements concerning Suharto's health, to be over 20% of a firm's value. Claessens et al. (2008) show that Brazilian firms, which provided contributions to (elected) political candidates experienced higher stock returns than firms that don't around the 1998 and 2002 elections. These firms were also able to subsequently access bank finance more easily. Faccio (2006) shows that political connections are more frequently found in countries with higher levels of corruption, more barriers to foreign investment, and less transparent systems. She also reports that the announcement of a new political connection results in a significant increase in firm value and that connections are diminished when regulations set more limits on official behavior. In a cross-country study, Faccio et al. (2006) find that politically connected firms are significantly more likely to be bailed out than similar non-connected firms, with those connected firms bailed out exhibit significantly worse financial performance than their non-connected peers at the time of the bailout and the next 2 years. Other evidence also suggests that political connections can influence the allocation of capital through financial assistance when connected companies confront economic distress. For example, in many countries, politically-connected firms borrow more than their non-connected peers (Charumilind et al., 2006; Chiu and Joh, 2004). Collectively, these studies show that “cronyism” can be an important driver of borrowing and lending activities in many markets, with high costs. Khwaja and Mian (2005) show that political connections, which increase financial access for selected Pakistani firms through governmentowned banks, imply economy-wide costs of at least 2% of GDP per year. 12 By identifying the impact of political relations on firm and country level performance measures, this literature offers an explanation as to why countries with higher concentrations of wealth show less progress in reforming their corporate governance regimes. Corporate governance reforms involve changes in control and power structures, with associated losses in wealth. As such, reforms can depend on ownership structures. The reluctance of insiders to reform is largely due to the existing rents that they could lose after reforms (see also Claessens and Perotti, 2007). In parts of East Asia, for instance, considerable corporate sector wealth is held by a small number of families. This suggests that wealth structures need to change in order to bring about significant corporate governance reform. This can happen through legal changes (gradually over time, or, more typically, following financial crises or other major events), and also as a result of direct interventions (such as privatizations and nationalizations, as during financial crises). Reforms can also be impeded by a lack of understanding. Partly this will be linked to political economy factors, perhaps directly related to ownership structures, as when the media is tightly controlled. These various relationships between institutional features and countries' more permanent characteristics, including culture, history, and physical endowments, remain an area of research. Institutional characteristics (such as the risk of expropriation of private property) can be long-lasting and relate to a 11 In the Netherlands, the corporate governance reform committee suggestions in 1997 stressed self-enforcement through market forces to implement and enforce its recommendations. A review of progress in 2003 (Corporate Governance Committee, 2003), however, showed that this model did not work and that more legal changes would be needed to improve corporate governance. Earlier empirical works had anticipated this effect (De Jong et al., 2005) as they documented little market response when the recommendations were announced. 12 They identify connected firms as those with a board member who runs for political office, and find that connected loans are 45% larger and carry average interest rates, although they have 50% higher default probabilities. Such preferential treatment occurs exclusively in government banks.

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country's physical endowments (Acemoglu et al., 2001). Both the origin of its legal systems and a country's initial endowments have been shown to be important determinants of the degree of private property rights protection (Beck et al., 2003). The role of culture and openness in finance, including in corporate governance, has also been found to be important (Stulz and Williamson, 2003). Cultural differences have also been shown to affect the flows of foreign direct investment and international mergers (Siegel et al., 2011), loan characteristics and the extent of risk sharing in international syndicated bank loan contracts (Giannetti and Yafeh, 2012), dividend payout ratios (Bae et al., 2010), and financial market linkages (Lucey and Zhang, 2010). More generally, financial globalization is thought to be an important force for reform (Kose et al., 2010; Stulz, 2005). The exact influence and weight of each of these factors is still unknown, however. More generally, the dynamic aspects of corporate governance reform are not yet well understood. The underlying political economy factors that may drive changes in the legal frameworks over time is the subject of a study by Rajan and Zingales (2003a). They highlight the fact that many European countries had more developed capital markets in the early twentieth century (in 1913) than for a long period after the Second World War. Importantly, many of these countries' capital markets in 1913 were more developed than the U.S. market at that time. A review of ownership structures at the end of the nineteenth century in the United Kingdom (Franks et al., 2003) shows that most UK firms had widely dispersed ownership before they were floated on stock exchanges. And in 1940 in Italy, the ownership structures were more diffused than in the 1980s (Aganin and Volpin, 2005). These three studies cast doubt on the view that stock market development and ownership concentration are monotonically related (positively and negatively, respectively) to investor protection. These papers identify the issues but do not clarify the channels through which institutional features alter financial markets and corporate governance over time, and how institutional features change (see also Rajan and Zingales, 2003b). As such, these papers are part of an ongoing research agenda on the political economy of reform. Work has shown the large political economy role in financial sector development (see Haber and Perotti, 2008 for a review and Haber et al., 2007 for many cases studies), particularly regarding how political economy determines property rights protection (e.g., Roe and Siegel, 2009). Roe (2003) shows specifically the political determinants of corporate governance in the U.S. (see also Roe and Siegel, 2009). The general thrust of this literature is that, while governments play a central role in shaping the operation of financial systems through macroeconomic stability and the operation of legal, regulatory, and information systems, there are some deeper constraints that cannot so easily be overcome. More general reviews (e.g., Djankov et al., 2008b; Fergusson, 2006) highlight the many unknowns in this area (and question some current findings). 6. Conclusions and areas for future research At the level of the firm, the importance of corporate governance for access to financing, cost of capital, valuation, and performance has been documented for many countries and using various methodologies. Better corporate governance leads to higher returns on equity and greater efficiency. Across countries, the important role of institutions aimed at contractual and legal enforcement, including corporate governance, has been underscored by the law and finance literature. At the country level, papers have documented differences in institutional features. Across countries, relationships between institutional features and development of financial markets, relative corporate sector valuations, efficiency of investment allocation, and economic growth have been shown. Using firm-level data, relationships have been documented between countries' corporate governance frameworks on the one hand, and performance, valuation, cost of capital, and access to external financing on the other. While the general importance of corporate governance has been established, knowledge on specific issues or channels is still weak. An important general caveat to the literature is that it has some way to go to address causality. This also applies to the following three areas: ownership structures and the relationship with performance and governance mechanisms; corporate governance and stakeholders' roles; and enforcement, both public and private, and related changes in the corporate governance environment. • Ownership structures and relationships with performance. Much research establishes that large, more concentrated ownership can be beneficial, unless there is a disparity of control and cash flow rights. Little is

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known, however, on ownership structures in complex groups, the role of multiple shareholders and the dynamics of ownership structures. Finer studies which analyze links between outside shareholders and their board representation deserve further attention. The specific subtopics that fall under this heading include: o Family-owned firms. Such firms predominate in many sectors and economies. They raise a separate set of issues, related to liquidity, growth, and transition to a more widely held corporation, but also related to internal management, such as intra-familial disagreements, disputes about succession, and exploitation of family members. Where family-owned firms dominate, as in many emerging markets, they raise system-wide corporate governance issues. o State-owned firms. These have specific corporate governance issues, with related questions like: What is the role of commercialization in state-owned enterprises? How do privatization and corporate governance frameworks interact? Are there specific forms of privatization that are more attractive in weak corporate governance settings? What are the dynamic relationships between corporate governance changes and changes in degree of state-ownership of commercial enterprises? Are there special corporate governance issues in cooperatively owned firms? o The corporate governance of financial institutions. The crisis has shown that the corporate governance of financial institutions has been an underhighlighted area, as there were massive failures at major institutions in advanced countries. Corporate governance at financial institutions has been identified to differ from that of corporations, but in which ways is not yet clear—besides the important role of prudential regulations, given the special nature of banks. In this area, more work is needed for emerging markets as well, in part related to the role of banks in business groups. While there is some research on state ownership, corporate governance of banks in emerging markets is little analyzed. Clarifying this will be key, as banks are important providers of external financing, especially for SMEs. o The role of institutional investors. Institutional investors are increasing throughout the world, and their role in corporate governance of firms is consequently becoming more important. But the role of institutional investors in corporate governance is not obvious and surely not clearly understood in emerging markets. In many countries, institutional investors have purposely been assigned little role in corporate governance, as more activism was considered to risk the company's fiduciary obligations. In some countries, though, institutional investors are being encouraged to take a more active role in corporate governance, and some do. What is the right balance here? Under which conditions are institutional investors most productive? o The governance of the institutional investors themselves. This is a topic that deserves more attention. Institutional investors will not exercise good corporate governance without being governed properly themselves. Moreover, the forms through which more activism of institutional investors can be achieved are not clear. For example, institutional investors typically hold small stakes in any individual firm. Some form of coordination is thus necessary, on the one hand. On the other hand, too much coordination can be harmful, as the financial institutions start to collude and political economy factors start playing a role. And what means are best, e.g., voting or exit? o Corporate governance mechanisms. More research focused on how corporate governance actually takes place would be very useful, even though data are hard to get. Most evidence shows that truly independent boards contribute to better firm performance and higher valuations. Relatively little evidence exists on executive compensation and managerial labor market mechanisms. Also the role of internal markets in business groups, as to whether they help to support efficient allocation of financial resources across member of the group, deserves more attention. • Corporate governance and stakeholders' roles. A similarly under-researched area is the role of other stakeholders. The analysis of employee representation, interactions with suppliers and civil society institutions and issues related to social corporate responsibility are almost empty research fields in emerging market countries (and in many advanced countries as well). Three specific subtopics that fall under this heading include: o Best practice in relation to other stakeholders. Little empirical research has been conducted on the relationships between corporate governance and stakeholders like creditors, and labor. When available, research refers largely to developed countries. o Corporate social responsibility and environmental performance. Under the general heading of corporate governance and stakeholders, is the need for more research on the role of corporate governance for social

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and environmental performance, including green financing. While many firms have been expressing a keen interest in this, little rigorous analysis has been conducted on how this relates to overall performance. o The impact on poverty alleviation. There are few studies on the direct relationship between better corporate governance and greater poverty alleviation and reducing inequality. While the general importance of property rights for poverty alleviation has been established (De Soto, 1989; North, 1990) and the role of financial sector development for poverty alleviation has been documented (Akhter and Daly, 2009; Demirgüç-Kunt and Levine, 2009; Mookerjee and Kalipioni, 2010; World Bank, 2007), the specific channels through which improved corporate governance can help the poor have so far not been documented. This is in part because much of the corporate governance research has been directed to the listed firms. However, much of the job creation in developing countries and emerging markets comes from small and medium-size enterprises. Different corporate governance issues arise for these firms. These require different approaches, which so far have not very much been researched. • Enforcement, both private and public, and dynamic changes. Enforcement is key to actually make corporate governance reforms work, but little is known on what drives enforcement. There is some evidence that when a country's overall corporate governance and property rights system are weak, voluntary and market corporate governance mechanisms have limited effectiveness. But only a few studies exist which analyze how to enhance enforcement in such environments. More general, enforcement needs to be studied more. Several subtopics exist under this heading. o How can enforcement be improved in weak environments? How can a better enforcement environment be engineered? The degree of public–private partnership in enhancing enforcement is presumably important, but understudied both from a theoretical and empirical perspective. What factors determine the degree to which the private sector can solve enforcement problems on its own, and what determines the need for public sector involvement in enforcement? o What are the roles of voluntary mechanisms? There is more evidence needed on how voluntary mechanisms (such as cross-listings, adopting codes of best practices or international accounting standards) can be most valuable. The interaction of cross-listings with domestic financial development is a further potentially useful research area as well, since cross-listing could undermine domestic financial development. o The corporate governance role of banks. In many countries banks have important corporate governance roles, as they are direct investors themselves or act as agents for other investors. And as creditors, banks can see their credit claim change into an ownership stake, as when a firm runs into bankruptcy or financial distress. Enhancing the corporate governance of banks may be effective in improving overall governance. o What are the lessons from corporate governance research that can be applied to regulatory corporate governance? Obviously, there were, and are continue to be, many failures in the oversight and performance roles of regulatory and supervisory agencies in advanced countries. This is not a new research topic, but much can be learned from corporate governance research in general, and from emerging markets specifically, also for advanced countries, on how to improve regulatory governance. o The dynamic aspects of institutional change. Finally, little is known about the dynamic aspects of institutional change, whether change occurs in a more evolutionary way during normal times or more abruptly during times of financial or political crises. In this context, it is important to realize that enhancing corporate governance will remain very much a local effort. Country-specific circumstances and institutional features mean that global findings do not necessarily apply directly. Local data are needed to make a convincing case for change. Local capacity is needed to identify the relevant issues and make use of political opportunities for legal and regulatory reform. Acknowledgments We would like to thank the editors of this issue, Craig Doidge and Peter Szilagyi and an anonymous referee for very useful suggestions. We also thank Melsa Ararat and Yishay Yafeh for valuable comments and Roxana Mihet for help with the data. Appendix A. Supplementary data Supplementary data to this article can be found online at doi:10.1016/j.ememar.2012.03.002.

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