Openness and Institutional Changes

1
Openness and Institutional Changes

• Minyuan Zhao
• Kathy Fogel
• Randall Morck
• Bernard Yeung
• June 2005

Presentation _at_ Business and Institution
Development, Paris June 2005
2
What is Institution?

• North (1990) institutions are the rules of the
  game in a society or, more formally, the
  humanly devised constraints that shape human
  interaction.
• Good institutions
• e.g., clearly defined and enforced property
  rights, disclosure requirements, efficient
  judicial systems, general law and order
• strengthen contracting parties property rights
• by mitigating information asymmetry and reducing
  the returns on opportunistic behavior
• ? facilitate contractual exchanges of goods and
  services across distances and over time
• Therefore, we refer to as good institutions
  constraints that reduce the cost of doing
  business and thus promote growth

3
What do we do?

• Institutional environment (behavioral
  constraints)
• Quality of government
• Trusting and trustworthy transactional behavior
• E.g., corporate governance (pyramids),
  intellectual property rights
• Institutional environment ? behavior
  observations, e.g.,
• Culture
• Short termism
• Entrepreneurial supply

4

• IB/IS environmental differences and firm level
  differences
• Paying attention to the institutional environment
  raises our understanding of IB/IS issues
• Open up new research agendas

5
Examples?

• Explain FdI
• How to explain outward fdi in poor corporate
  governance locations?
• How to explain inward fdi in poor institutional
  environment locations?
• MNE management, investing in low corporate
  governance location?
• Experiences help entry success?
• How to quantify experiences?
• Combining corporate culture?
• How does change in compensations affect
  managerial culture?
• How to develop an incentive system to motivate
  people in a different culture?
• Protection of property rights?
• Why do we have Microsofts building such a big lab
  in China?
• Family firms?
• Impact of MNEs on local business environment?

6
The Research Question

• Does openness lead to institutional improvement?
• Some backgrounds
• Capital market development plays a critical role
  for growth (e.g., Levine and King 1993)
• Locations with poor property rights, corrupt
  government, and generally low on the rule of law
  have underdeveloped capital markets (La Porta, et
  al. 1997, etc.)
• Locations with such under developed institutions
  have concentrated control of corporate assets
• Super rich with huge economic power use their
  resources to preserve the status quo, hurt
  institutional development (Morck et al. 2000,
  Rajan and Zingales 2003), Morck, Wolfenzon, Yeung
  (2004), Perotti and Volpin (2004), Acemoglu et
  al. (2005) Stulz (2005))
• Rent-seeking type political economy

7
The Research Question

• Does openness lead to institutional improvement?
• Many say yes (e.g., Rajan and Zingales 2003,
  Johnson and Subramanian 2005, Stulz 2005, Morck
  Wolfenzon, Yeung (2004))
• Openness raises the benefits of institutional
  improvements, and
• foreign competition reduces the rent-seekers
  resources to lobby for preserving the status quo
• Some says no (e.g., Rodrik)
• Empirically, the relationship between openness
  and institutional development is mixed
• Examples Malaysia, Mexico

8
Our Approach

• Derive an explanation for the mixed results
• First, set up a general framework for a closed
  economy
• Then, add openness
• No need for rent-seeking
• Take the thoughts to the data

9
Intuition

• Institutional development needs the government to
  set up and enforce laws and regulations
• Good institutions come with a cost
• A government makes the decision by matching
  marginal costs and marginal benefits

10
Benefits of Institutional Development

• The benefits depend on the composition of
  players
• Small firms and potential entrants
• Highly dependent on sound institutions
• Business groups have internal markets (for
  capital and talent)
• Less reliant on external institutions
• The benefits are high, if
• there is a high entry push effect good
  institutions can induce substantial entries, and
  if
• there is a high external reliance effect
  existing firms growth are reliant on external
  institutions

11
The thinking leads to

• Path dependence even without rent-seeking
  behavior or increasing returns to scale
• good institutions in the past lead to
• high entry push and external reliance effects
• Stages of institutional development
• Where do the entry push and external reliance
  effects come from?
• Need primary institutions, e.g., education,
  efficient and uncorrupt government, to create for
  citizens the willingness and the channel to
  invest in entrepreneurial capabilities
• ? Then the development of new businesses, which
  crave for supports for further expansion
• Advanced institutional development e.g.,
  institutions that facilitate capital market
  development.

12
Model Setup

• Institutional constraint ? ? gt 1
• Firms ability to get around the constraint z 0
  z 1.
• For a firm of type z

13
Policy Choices

• Position External Reliance Effect

14
Policy Choices

• Position External Reliance Effect
• Slope Entry Push Effect

15
Openness

• Assumptions
• The old single sector is split into an importing
  sector (M) and an exporting sector (X)
• Small open economy model taking the world price
  pw as given
• Foreign firms not affected by domestic
  institutions (e.g., have alternative mechanisms
  to overcome the adverse institutions in host
  countries (Desai et al., 2004 Zhao 2004))

16
The New Market Equilibrium

• Import substitution sector
• Only higher z firms survive
• Less external reliance
• Foreign owned production is partly value
• Entry push less valued

• Exporting sector
• Lower z firms survive
• More external reliance
• Elastic demand ? Entry does not reduce price
• More entry push

17
Our Discussion So Far
Primary institutional environment / initial
conditions
The distribution of firms with different
dependence on external institutions
Pool of surviving firms
Governments incentive to build/maintain good
institutional environment
18
Rent Seeking

• A government interested in side-payments
• Firm-specific s s(z, ?) lt p(z, ?), sz gt 0 and
  s? gt 0.
• Thus, .

On the one hand, firms are more ready to pay s
under weaker external protection, i.e., s? gt 0.
On the other hand, weaker institutions reduce
the pool of potential contributors (?z0/?? gt 0).
19
Rent Seeking and the Distribution of Firms

• When there is a cluster of high z firms
  dominating the economy,
• s? gt 0 ? keep the ? high
• with few potential entries f(z0), the potential
  contributors are not important considerations
• That is, a rent-seeking government is less
  motivated to make institutional improvement if
  there is a strong base of high z firms and if
  there are few potential entries in sight.

20
Rent Seeking and the Impact of Openness

• Openness generally discourages rent-seeking
• A high ? can no longer keep p(z, ?) high for the
  high z firms as effectively as before
• In an open economy, the domestic tax base may
  shrink rapidly with a high ?.

• However,
• When foreign firms are more sensitive to local
  institutions, a high ? is a way to deter
  competition.
• If collecting rent from foreign firms proves
  difficult, openness may even induce a reverse in
  institutional development to preserve the local
  interest.

21
Taking the Thoughts to the Data

• Empirical premise
• Increase in openness is associated with
  improvement in advanced institutional development
  if there exist strong entry push and external
  reliance effects.

22
Proxy for Entry Push and External Reliance Effects

• Good primary institutions at t0
• Educational attainment
• Source World Development Indicator
• Law and order
• Corruption
• Bureaucratic quality
• Source Intl Country Risk Guide
• The extent to which family pyramids or state
  control the top ten business enterprises (20
  threshold)
• Source Fogel 2004

23
How is the Development of Advanced Institutions
Associated with Openness

• Advanced institutional development
• Capital Market Development
• Two considerations
• Long term phenomenon need long term trend
  variable
• Global trend in openness and capital market
  development need to detrend.
• Step one
• Time trend in stock market capitalization/GDP
• Time trend in openness (imports exports)/GDP,
  (capital inflow outflow)/GDP, tried tariffs
  collection over trade volume.
• Estimate a global trend using the two
• Step two
• Examine the differences between the above- and
  below- trend groups in the primary institutional
  development variables, which proxy for the entry
  push and external reliance effects

24
Change in Market Capitalization Associated with
Increased Trade Openness
25
Conclusion

• When a country opens up, the marginal benefit of
  institutional improvement depends on the entry
  push and external reliance effects.
• The primary institutions before openness shape
  the type of firms in the economy, and thus the
  path of institutional development after openness.
• Stages of development and diverging paths