Political Connectedness, Corporate Governance, and Firm Performance

Abstract

In this paper, we present and test a theory of how political connectedness (often linked to political corruption) affects corporate governance and productive efficiency of firms. Our model predicts that underdeveloped democratic institutions that do not punish political corruption result in political connectedness of firms that in turn has a negative effect on performance. We test this prediction on an almost complete population of Slovenian joint-stock companies with 100 or more employees. Using the data on supervisory board structure, together with balance sheet and income statement data for 2000–2010, we show that a higher share of politically connected supervisory board members leads to lower productivity.

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Notes

  1. 1.

    The term “environment” refers to the nature of monitoring and punishments, as well as to economic decisions in which the bureaucrats participate (Banerjee et al. 2012).

  2. 2.

    The quality of institutions in this paper resembles an approach of Bhattacharyya and Hodler (2010) that compares probability p of electing new politicians in the next period with probability q of not being able to replace the incumbent elite with the new elite if people do not support the incumbents anymore. As we discuss below, a small difference between p and q signals underdeveloped democratic institutions as people’s vote has little impact on the probability that the new elite will come to office, while a large difference implies that the incumbents are likely to stay in office only if the people want them to stay.

  3. 3.

    Faccio (2006) assembled a database of 20,202 publicly traded firms in 47 countries. She identified a firm to be politically connected if at least one of its large shareholders (controlling more than 10 percent of voting shares) or one of its top officers (CEO, president or vice-president) was a member of parliament, a minister, or a person closely related to a top politician or political party. Slightly less than 3 percent of firms in the total sample were identified as being politically connected. However, there is a high cross country variation. In Russia, for example, 86.75 percent of the market capitalization was represented by politically connected firms.

  4. 4.

    More generally, with the fall of the communist regime, Central European transition countries moved virtually overnight into the ranks of the most open economies in the world, thus defying the widely accepted infant industry thesis that firms in emerging market economies require a long period of protection before being able to face world competition.

  5. 5.

    The most recent findings by the Slovenian anti-corruption agency, based on a case-by-case investigation, point to systemic corruption risks mostly related to the privileged position of SOEs in the Slovenian economy, particularly when it comes to access to finance and investment opportunities. The European Commission warns that the distortion of market principles and rent-seeking practices threaten to block the privatization process (European Commission 2014).

  6. 6.

    We describe the privatization process in more detail in Chapter 4.

  7. 7.

    The previous (Yugoslav) economic system of self-management was based on social ownership. The firms belonged to society as a whole, but were managed by workers of self-managed enterprises on the principle of one person one voice. See Prašnikar and Svejnar (1993) for details.

  8. 8.

    In this context, they treat legal corruption as arising when the elite prefers to hide corruption from the population and the costs of hiding are a so-called investment in “legal barriers.” Investment in legal barriers and “insurrections” crucially depends on accountability and initial inequality among the population. It can be proven that, in the case of low initial inequality, legal corruption arises in the case of low accountability. In this case, the legal barriers arise in every period as well. On the other hand, in the same case of low initial inequality but high accountability (for example, like in Scandinavian countries), legal corruption and legal barriers do not arise and the economy stays in this equilibrium.

  9. 9.

    Gill and Kharas (2007) and Lee and Oh (2007), for example, look at the arbitrariness of corruption in East Asia and note that Indonesia and the Philippines were particularly affected by political corruption that occurred during and after the lengthy dictatorships.

  10. 10.

    Collins (1998) reports that some forms of corruptive practices can already be found in 3000 B.C. What has changed during history is the form of corruptive practices. However, the historical perspective shows that the ethical reform of corruption is important as some of the action solutions taken against corruption have been as problematic as corruption from the ethical perspective (Nielsen 2003).

  11. 11.

    For the sake of simplicity, we also exclude the concept of corruptive income based on natural resources. Resource income largely depends on a country's resource abundance and our model is designed for a country that is not rich in natural resources.

  12. 12.

    As noted by Bhattacharyya and Hodler (2010), there are different motives for why the incumbent elite also cares about the people’s welfare and the performance of the economy. First, the economic conditions in general determine the salary of the incumbent elite, and second, the status and influence of the elite in the international community depends on the welfare of citizens.

  13. 13.

    In fact, a third model of privatization was also proposed by Ribnikar and Prašnikar that favors the idea of converting all assets of socially owned firms into preferential shares of retirement funds. New owners were to invest funds in firms and acquire governance power. All three models are described in details in Prašnikar and Svejnar (1993).

  14. 14.

    In 2002, Sandoz took over Lek, a pharmaceutical company that was one of the largest firms in Slovenia. Although this takeover worked well for the company, speculations that the existing management team reaped substantial rewards by trading on the basis of internal information have never been dispelled. The prevalent position taken by politicians was not to privatize the most successful Slovenian companies to foreigners, if not necessary.

  15. 15.

    The Law did not apply to enterprises providing special public services, banks and insurance companies, enterprises engaged in the organization of gambling, enterprises that were transformed under the Law on Cooperatives, enterprises that were transformed under the forestry legislation, and firms in the process of bankruptcy.

  16. 16.

    As reported by the study of Domadenik et al. (2008) that analyzed the ownership structure in 157 big and medium-sized Slovenian firms, slightly more than one-half of those firms were privatized primarily to insiders. The average share ownership was 31 percent by insiders, 34 percent by state and investment funds, 21 percent by other firms, and 13 percent by other owners (banks and direct state ownership).

  17. 17.

    This is Abramovitz's famous “measure of our ignorance.”

  18. 18.

    Intangible resources in countries with underdeveloped capital and financial markets crucially depend on the ability of firms to generate internal funds. This is especially the case in Slovenia, as shown by Domadenik et al. (2008).

  19. 19.

    The correlation between an individual’s wage and productivity is high even when the markets are not perfectly competitive.

  20. 20.

    If gender discrimination exists, firm performance would be better off in cases of a more balanced recruitment policy for managers and supervisory board members. Empirical evidence is mixed, ranging from positive effects of diversity management (Carter et al. 2003; Singh and Vinnicombe 2004; Smith et al. 2006) to no effect at all (Kochan et al. 2003).

  21. 21.

    Companies were not required to report names of their supervisory board members before 2007, however, and we were hence only able to gather complete information about supervisory board members in 308 firms; 155 of them operated in the tradable sector and 153 in the non-tradable sector. It is important to note at this point that of the 308 companies which had a supervisory board and were used in the analysis, 292 had their own supervisory board. The remaining 16 companies did not have their own supervisory board but were owned and controlled by a parent company with a supervisory board. Thus, for these 16 companies supervisory board data from the parent company were used as a proxy to determine how important business decisions were made. We assumed that political influence from the parent company was also present in the decision-making of the subsidiary company.

  22. 22.

    In particular, we carefully checked if any supervisory board members had a political affiliation defined as being a candidate for a local and/or state-level elected position, a member of a political party or continuously expressing public support for a given political party.

  23. 23.

    From the AJPES registry, we were able to obtain balance sheet and income statement data for most of the companies, except companies facing compulsory settlement, companies in bankruptcy procedure, and those companies that had undergone a significant organizational change that prevented us from making a consistent panel of financial data.

  24. 24.

    Also see Bole et al. (2010) for details.

  25. 25.

    OLS estimates may be obtained from the authors upon request.

  26. 26.

    The coefficient is statistically significant at the 10 percent level.

  27. 27.

    Gupta et al. (2008), for example, show on a panel of Czech data that better performing firms were privatized first and that ignoring this selection leads to a biased estimation of the effects of privatization in existing studies.

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Acknowledgments

Domadenik's and Prašnikar’s  research in this paper was in part supported by the Slovene Research Agency’s Grant No. J5-227. Jan Svejnar benefitted from a Grant from the Grant Agency of the Czech Republic (Grant No. P402-15-24642S). The authors would like to thank two anonymous referees and Editor for their helpful comments.

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Correspondence to Polona Domadenik.

Appendix

Appendix

See Table 9.

Table 9 Supervisory board composition by period and industry

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Domadenik, P., Prašnikar, J. & Svejnar, J. Political Connectedness, Corporate Governance, and Firm Performance. J Bus Ethics 139, 411–428 (2016). https://doi.org/10.1007/s10551-015-2675-4

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Keywords

  • Political connectedness
  • Political corruption
  • Corporate governance
  • Productivity
  • Politicians
  • State-owned enterprises