Estimating the Value of Political Connections

As the Indonesian economy went into a downward spiral in the latter half of 1997, there was much speculation and debate as to the reasons behind the sudden decline. Most explanations gave at least some role to investor panic, which had led to a massive outflow of foreign capital. At the root of this hysteria, however, were concerns that the capital that had flowed into Indonesia and elsewhere in Southeast Asia had not been used for productive investments. Much of this discussion focused on the role of political connections in driving investment. The claim was that in Southeast Asia, political connectedness, rather than fundamentals such as productivity, was the primary determinant of profitability and that this had led to distorted investment decisions. Obviously, the degree to which this type of problem was truly responsible for the Asian collapse depends very much on the extent to which connectedness really was a primary determinant of firm value. In making the argument that this was in fact the case, anecdotes about the business dealings of President Suharto’s children were often cited as evidence. Such stories suggest that the value of some firms may have been highly dependent on their political connections. However, investigations in this area have not progressed beyond the level of case study and anecdote. That is, there has been no attempt to estimate the degree to which firms rely on connections for their profitability. There are numerous difficulties that would affect any attempt to value political connections, which probably accounts for the paucity of work in this area. In countries where political decision-making is decentralized, simply defining political connectedness is an extremely complicated proposition. For example, in India, analyzing a firm’s political associations would require information on its relationships with numerous government decision-making bodies as well as some way of aggregating these connections. Even with a specific measure in mind, collecting the appropriate data would be difficult because business–politics relations is often a taboo topic of conversation and because connections tend to shift considerably over time. Finally, assuming that an appropriate measure were found, it is not clear how one would estimate the value of these connections. Simple measures of profitability are unsuitable: in equilibrium, well-connected firms may not earn higher profits, even if they are earning tremendous political rents, because of the resources they may be required to devote to rent-seeking activities. Also, it is plausible that unobservables such as business acumen are correlated with the ability to establish political connections. By looking at Indonesia, I am able to overcome these problems. Because of Indonesia’s highly centralized and stable political structure (until the very end of Suharto’s reign), it is possible to construct a credible index of political connectedness. Moreover, my “event study” approach described below allows for a relatively clean measure of the extent to which firms relied on these connections for their profitability. To infer a measure of the value of connections, I take advantage of a string of rumors about former Indonesian President Suharto’s health during his final years in office. I identify a number of episodes during which there were adverse rumors about the state of Suharto’s health and compare the returns of firms with differing degrees of political exposure. First, I * Graduate School of Business, 614 Uris Hall, Columbia University, 3022 Broadway, New York, NY 10027. I thank George Baker, Richard Caves, Gary Chamberlain, Rafael Di Tella, Tarun Khanna, Sendhil Mullainathan, Jan Rivkin, James Schorr, Dr. Sjahrir, Joseph Stern, Peter Timmer, Lou Wells, and seminar participants at Harvard University and the University of California at San Diego for many helpful comments on earlier versions of this paper; two anonymous referees provided thoughtful insights and suggestions. I am also very grateful to the many members of the Indonesian business community who were kind enough to meet with me during my visits to Jakarta. Any remaining errors are my own.