Investor Protection and Foreign Stakeholders

This paper investigates the impact of investor protection laws on foreign bilateral investments, namely foreign equity portfolio investments and foreign bond portfolio investments. Asset prices reflect the joint behaviour of foreign and domestic investors so that we need to look at foreign allocation decisions to disclose the impact of corporate governance on foreign stakeholders. Previous work originated from La Porta, Lopez-de-Silanes, Shleifer and Vishny (1998) points to an important role of institutions, such as legal investor protection, in explaining development of financial markets but usually suffers from small samples and weak results. In our analysis we adopt the Coordinated Portfolio Investment Survey, annually released by the IMF, for the period 2001-2006. This dataset contains bilateral portfolio positions allowing us, on the one hand, to disentangle the effect of investor protection on foreign investment and, on the other hand, to have a number of observations large enough to consistently test the role of investor protection legislation.

Our innovative contribution to the existing literature is twofold: first, we evaluate the impact of investor protection laws on bilateral foreign investment to be able to separate the foreign from the domestic effect; second, we properly account for the interaction of various governance mechanisms on stakeholders endowed with different rights and interests.

Indeed, the analysis of the effects of investor protection laws ought to carefully account for the conflicting interests of various stakeholder groups within the corporation. The corporate governance literature has analyzed the complex mechanisms of conflict of interests between shareholders and creditors, suggesting that the potential conflict between equity and debt claimants is primarily in terms of wealth expropriation and risk shifting (Jensen and Meckling (1976)). Specifically, while strong shareholder rights are likely to benefit foreign shareholders ("direct" effect) they may also deter foreign bondholders ("indirect" effect) as shareholders are more prone to risk-taking activities than optimal for creditors. On the other hand, strong creditor rights are likely to attract foreign bondholders ("direct" effect) but may deter stock investments ("indirect" effect) if firms are induced to engage in risk-reducing processes, such as mergers andacquisitions, that are likely to be value-destroying (Acharya, Amihud and Litov (2008)). Ultimately, the question of the impact of investor protection provisions on foreign stakeholders -which is the focus of the present paper- is an empirical one and depends on foreigners’ perception of the balance between different interests.

Our results show, first, that strong shareholder rights (creditor rights) stimulate foreign equity (bond) portfolio investments. Secondly, foreign shareholders show to appreciate strong creditor rights - which potentially mitigate the riskiness of projects - while bondholders are negatively affected by strong shareholder rights - which might induce the firm, especially if high levered, to engage in risky asset portfolios.

The immediate implication to draw from this picture is that strengthening investor protection is not a universally desirable policy. Moreover, the evidence of the relatively large "indirect" effect of investor protection on foreign stakeholders suggests that ignoring it entails missing not only one part but possibly a major part of the story.