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Democracy, rule of law, and corporate governance—a liquidity perspective

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Abstract

This study examines whether and how democracy and rule of law—two overarching country-level governance variables—influence corporate governance. Given that corporate liquidity (cash holdings) is a good channel for examining the quality of corporate governance, the effects of democracy and rule of law on corporate governance can be identified using the liquidity approach. A review of 67 countries from 1996 to 2010 demonstrates that democracy and rule of law indeed have bearings on corporate governance. More specifically, results indicate that firms are more inclined to hoard cash to take advantage of growth opportunities when the level of democracy is higher or rule of law is stronger, suggesting that agency costs are lower and interests of managers and shareholders are more aligned under such circumstances. In addition, the negative effect of debt issuance and dividend payment on cash is more pronounced when the level of democracy is higher or rule of law is stronger, suggesting that these two approaches become more effective in reducing agency costs and transitively cash holdings under such circumstances. Moreover, the positive effect of democracy and rule of law on corporate governance appears to be reinforced when rule of law is stronger and the level of democracy is higher, respectively. Furthermore, higher level of economic development helps reap the benefit of democracy and rule of law in terms of improving corporate governance and reducing agency costs.

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Notes

  1. According to Fligstein and Choo (2005), “the political system of a particular society (i.e., democracy vs. dictatorship) and the existence of the rule of law are important pre-conditions for understanding corporate governance structures.”

  2. In addition to the literary arguments, existing literature has also provided empirical evidence suggesting the relationship of corporate governance to investor protection and rule of law (La Porta et al. 1998, 1999, 2000b; Edwards and Fischer 1994; Gorton and Schmid 2000; Kuipers et al. 2009; Doidge et al. 2007).

  3. Countries are divided into developing and developed countries to match our econometric model, where the level of economic development is included as one of independent variables because it might have bearings on how VA and RL influence corporate governance.

  4. It should be noted that we do consider other national-level governance indicators such as political stability and absence of violence, government effectiveness, regulatory quality, and control of corruption in the pilot study. However, they are eventually excluded because including them results in severe multicollinearity.

  5. This study builds upon seminal liquidity literature (e.g., Dittmar et al. 2003; Dittmar and Mahrt-Smith 2007; Bates et al. 2009), which uses the OLS or the fixed-effects panel data model to examine how cash is influenced by its determinants.

  6. Results thus obtained are more conservative in the sense that the Huber/White/sandwich robust standard errors are generally larger than regular standard errors such that the coefficients become less significant or turn insignificant with this approach.

  7. Industry dummy variables as well as other variables that are not time-varying are not included in the model because they get dropped with the fixed-effects panel estimation.

  8. Dittmar et al. (2003) found that the sensitivity of cash to investment opportunities is higher when shareholder rights are stronger, suggesting that the interests of managers and shareholders are more aligned when shareholders are better protected such that managers are inclined to hoard cash to take advantage of greater investment opportunities under such circumstances.

  9. The coefficients on DIV are generally positive (Tables 3, 4), indicating that the positive effect of DIV on cash overwhelms its negative effect such that the net effect is positive.

  10. When regular rather than cluster-robust standard errors are used for statistical inference, the coefficient of RL \(\times \) DVPMT \(\times \) DIV is significantly negative in Column 5, indicating that the negative effect of RL on the cash sensitivity to DIV is stronger for low democracy countries with higher level of economic development than for those with lower level of economic development.

  11. Twelve countries joined the EU in mid-2000s, with the majority of them entering the EU in 2004. Bulgaria and Romania became members in 2007. The data for Romania are unavailable, rendering the number of these EU countries reduced to 11

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Acknowledgments

This work was funded by National Science Council (NSC 100-2410-H-194-025-), Taiwan and Jiangxi Normal University, China

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Authors and Affiliations

  1. International Institute for Financial Research, Jiangxi Normal University, 99, Ziyang Ave., Nanchang, 330022, Jiangxi, China

    Naiwei Chen

  2. Department of Finance, National Chung Cheng University, 168, Sec. 1, University Rd., Min-Hsiung Township, Chia-yi County, 621, Taiwan

    Tsai-Chen Yang

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  1. Naiwei Chen
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Correspondence to Naiwei Chen.

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Chen, N., Yang, TC. Democracy, rule of law, and corporate governance—a liquidity perspective. Econ Gov 18, 35–70 (2017). https://doi.org/10.1007/s10101-016-0182-4

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