Proving Adam Smith wrong
Michael Klein,
Mierta Capaul,
Simeon Djankov
and Tim Harford
International
Finance Corporation
Adam Smith would not have been surprised by Enron, Parmalat and the rest. The father of economics famously believed that joint stock companies could never prosper because managers had no incentive to take care of the interests of widely dispersed shareholders. “Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company,” he wrote in The Wealth of Nations.
But Smith was wrong. You might not know it to read the headlines, but cases of serious fraud remain exceptional. In most rich countries, tiny investors continue to put their money into vast companies over which they have no effective control, correctly believing that they will profit from the arrangement.
Given the varied opportunities for managerial fraud and expropriation, and the difficulty small shareholders have in coordinating themselves to prevent their being robbed, the success of joint stock companies is a minor miracle. It is also one of the cornerstones of modern prosperity. Obstacles that seemed insuperable to Adam Smith in 1776 have been surmounted, and the occasional scandal helps to keep investors and regulators alert. While there is room for improvement, the fact that abuses are so rare compared with Smith’s fears is a testament to the high standards of corporate governance in the developed world.
So Smith was too pessimistic about large corporations in rich countries. Sadly, he has been proved right (so far) when it comes to corporate governance practices in much of the developing world. In many poor countries, enforcement of company law is weak and various forms of managerial expropriation are sometimes perfectly legal.
Poor corporate governance in developing countries is a serious matter. It is true that some countries, such as South Korea, managed to join the industrialised world after an impressive record of sustained growth, despite flaws in corporate governance. But that strong record belies the fact that even South Korea has much to gain from improved standards.
Leading families continue to control the chaebol through Byzantine systems of cross-holdings. The result is that investors have little confidence in South Korean shares, which trade at a notorious discount. If governance in the country could be strengthened, its businesses would be able to secure cheaper finance – essential for the continued progress of a high-investment, high-innovation economy.
The cost of poor governance is very high. Work by Bernard Black, Hasung Jang and Woochan Kim on firms in Korea finds that well-governed firms trade at a premium of 160 per cent compared with poorly governed firms. Professor Black’s work on Russian firms suggests that the valuation gap between the best and worst can be far larger – many hundreds of times.
If emerging market companies cannot attract equity capital, they are doomed to remain on a small, inefficient scale. If small businesses struggle to grow, so will poor countries.
This is a serious problem for the world’s poor, and the World Bank and the International Finance Corporation are working hard to improve it, in part by working with the Organisation for Economic Cooperation and Development (OECD) to provide guidance.
The OECD’s new Principles of Corporate Governance, approved in April 2004, are a welcome effort to set out the best possible standards. They were informed by the largest ever consultation of developing countries on corporate governance, facilitated by the World Bank. The task now is to make those high standards a reality for developing countries.
The challenge is to create approaches that work well in developing countries, where some of the problems are different. For example, in a small country such as Chile, which has a close-knit business community, it is unwise to rely too heavily on scrutiny by ‘independent’ directors. (Chile rightly recognises that investors need different forms of protection.) Many other developing countries also have problems finding suitably independent directors.
A second difference between developed and developing countries is that developed countries have a much lower concentration of ownership and cross-ownership. Complex rules such as cumulative voting for minority shareholders, an important part of the debate in rich countries, are largely irrelevant here.
A third difficulty is that courts in developing countries are often not effective, taking considerable time and expense to process even relatively simple issues such as breach of contract. More complex efforts, such as trying to sue directors for malfeasance, are unlikely to be rewarding in many countries with weaker institutions.
More progress is therefore likely to be made with simple ‘bright-line’ rules which go some way towards improving governance and can be implemented without much difficulty. Two examples may serve: improved disclosure of directors’ financial interests, and mandatory dividends set at a proportion of profits. The latter measure forces cash payouts to all shareholders, and while profits can be misstated, it is risky to do so because several institutions, including the tax authorities, are monitoring compliance.
The World Bank is helping developing countries to reform corporate governance, recognising reality but still giving investors good reason to be confident. Two World Bank efforts are worth noting. First, the World Bank is systematically reviewing country compliance with the OECD’s corporate governance code, part of a broader programme called Reports on the Observance of Standards and Codes (www.worldbank.org/ifa/rosc_cg.html). Over 20 reports are already available. Second, the Doing Business project (rru.worldbank.org/ DoingBusiness), which benchmarks regulations across the world, will publish detailed, comparable data on the corporate governance practices of well over 100 countries, from the summer of 2004.
The desire to see poor people secure good jobs in thriving, growing companies is reason enough to care about this issue. But while poor governance is already an obstacle to development, it is about to become a critical topic for foreign-policy makers because in the future, public policy on corporate governance will be about securing the rights of cross-border investors.
Rich countries have an increasing proportion of retired people. Some poor countries, notably China, are not far behind them on the demographic curve. The result is that retirees from both types of nation will be seeking to fund their pensions with productive investments all over the world.
This is a great opportunity for the developed and the developing world to gain from working together. More and more money will flow across borders, if investors can be confident of getting it back. If they cannot, the wasted opportunities will be staggering and will grow over the years.
By 2100, the funds seeking trustworthy, productive companies in today’s developing countries are likely to top US$500,000 billion, assuming economic growth continues at 20th century rates, so that the typical global citizen owns the same size portfolio as US citizens do today. The foreign policy challenge of the 21st century is to make those cross-border investments possible, and help rich and poor alike.
A shorter version of this article was published in the Financial Times, May 3 2004.