The Impact of Corporate Governance on Investment Returns in Developed and Developing Countries

We set out to shed light on three conundrums that exist in the literature on investment: why do investments out of different sources of finance earn different returns, why do different studies report different patterns of returns, and why do companies in developing countries make greater use of external capital to finance their investment than do companies in developed countries? To answer the first question, we assume that firms have different investment opportunities, and managers face different constraints when pursuing their own goals via their investment policies. In particular, managers who wish to undertake low return investments in countries with strong corporate governance systems will prefer to rely on internal cash flows, managers making similar investments in countries with weak corporate governance systems are less constrained to use the equity market. At the same time we postulate that managers with very attractive investment opportunities will often favor equity over debt as a source of external capital. These considerations help explain why investments financed in different ways can exhibit significantly different rates of return. In addition to clarifying some issues that were heretofore unresolved in the literature, our results contribute to the growing body of work that stresses the importance of institutional differences across countries in explaining differences in performance. In particular, we relate differences in corporate governance systems to differences in investment performance. Where other studies focus on legal institutions and ownership structures when testing hypotheses about corporate governance, we find considerable support for the hypotheses that there are significant differences in corporate governance institutions between developed and developing countries. Our results also suggest that modest reforms like stronger accounting standards and better enforcement of contracts can have a significant impact on performance. JEL: G32, L21, O16