12 November 2013

IMF Working Paper: International corporate governance spillovers - Evidence from cross-border mergers and acquisitions

Authors: R Albuquerque, L Brandao-Marques, M A Ferreira, and P Matos

Foreign direct investment (FDI) has been an increasingly important component of the financial globalisation phenomenon in recent decades. According to the World Development Indicators database, the yearly average ratio of the world FDI net inflows to gross domestic product has increased nearly four times from 0.7% in the 1980’s to 2.6% in the 2000’s and, consequently, the foreign share of aggregate output has risen dramatically. Cross-border mergers and acquisitions (M&A) represent more than half of the FDI (Organisation for Economic Co-Operation and Development (2007)) with the value of cross-border deals exceeding that of domestic M&As during the mid-2000s merger boom and also more recently (Economist (2007), Bloomberg (2012)).

FDI can be a source of valuable technology and know-how by promoting linkages with host country firms, which can generate improvements in productivity. However, empirically there is mixed evidence of positive productivity spillovers associated with FDI due to data limitations and multiple effects at play. If foreign firms achieve higher productivity at the expense of lower productivity of host country firms there may be adverse effects of FDI on productivity due to competition. Further, FDI spillover effects may be limited due to lack of absorptive capacity in developing countries.

One overlooked aspect is that FDI can be a source of corporate governance improvements in the host country. An active international market for corporate control can substitute for weak investor protection and legal institutions in the host country. Research supports the idea that cross-border M&As bring corporate governance improvements to target firms.

In this paper, the authors investigate whether the change in corporate control following a cross-border M&A leads to changes in corporate governance of non-target firms that operate in the same country and industry as the target firm. The authors focus on the strategic complementarity in governance choices between the target firm and its rival firms in the local market. They take the view that corporate governance is affected by the choice of other competing firms.

To provide guidance for their empirical analysis, the authors develop a simple industry oligopoly model, which captures the idea that rival firms operating in a given industry change their governance in response to competitive forces. The spillover effect occurs as firms in an industry recognise that corporate governance is used more efficiently by the target firm and therefore strengthen their own governance as a response.

They conclude that they find a positive relation between cross-border M&A activity in an industry and corporate governance of non-target firms that operate in the same industry as the target firm. Cross-border M&A activity is especially effective in improving corporate governance in more competitive industries and when the investor protection in the acquirer firm’s country is stronger than the one in the target firm’s country. Furthermore, cross-border M&As lead to increases in firm valuation and productivity of non-target firms, suggesting that foreign direct investment not only affects corporate governance mechanisms, but also has real effects on firm valuation and productivity.

The findings establish a direct link between foreign direct investment and the adoption of practices that promote corporate accountability and empower shareholders worldwide. To their knowledge, their paper is the first to establish that the effect is not restricted to the target firm but spreads out to the target firm’s industry rivals. Thus, foreign direct investment generates positive externalities across firms that operate in the target’s industry. Their findings highlight that market forces, namely the international market for corporate control, are able to promote good corporate governance practices around the world.

IMF-working paper

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