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Pro-market institutional reforms
and firm performance
Name: R.A.C. van Dongen (s2477165) Study Programme: MSC IFM
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Abstract
The paper analyzes how pro market institutional change affects firm performance in countries from the Latin American region. Using the signaling theory, four different dynamic components are constructed: Intensifying and fading pro-market reforms and intensifying and pro-market reversals. The Heritage index of economic freedom is used to measure the pro-market institutional change. The paper proposes an improve in firm performance with intensifying pro-market reforms and fading pro-pro-market reversals and a decrease in firm performance for intensifying pro-market reversals and fading pro-market reforms. The hypotheses are tested on a sample of 886 firms, from different industries, originating from Latin American countries.
Introduction
When academic papers discuss the strategy and performance of firms, usually two perspectives are considered: a resource-based and an industry-based view. The industry-based view argues that a firm’s performance and strategy largely determine the conditions of the industry (Porter, 1980), whereas the resource-based view emphasizes the differences between firms to explain the performance and strategy (Hart, 1995). Although both views are insightful, they often ignore the underlying formal and informal institutions, which form the context of both views. Peng (2008) states that the formal institutions (laws and regulations), informal institutions (norms, values and beliefs) and the change in these institutions over time, also called “the rules of the game”, shape the behavior and performance of firms in a society. The main task of institutions in an economy is to reduce the transaction costs and reduce uncertainty faced by firms. Institutions shape the social and organizational behavior of the environment a firm has to operate in. (Hoskisson, et al., 2000).
3 the 1980’s when economic stagnation forced policy makers to rethink the model of development (Sachs & Warner, 1995).
Research shows inconclusive results regarding the effect of market oriented institutional change. Almost all research implies the beneficial effect of pro-market institutional change for countries. Bhaumik et al. (2014) discovered that certain restrictive institutions, such as employee rights, have a positive effect on firm performance while other more deliberating institutions, such as an open business environment, have a detrimental effect on firm performance. However, results from research regarding the effect of pro-market reforms on firm performance are inconclusive. Some propose an improvement of firm performance after pro-market institutional change (Banalieva et al. 2015; Cuervo-Cazurra et al. 2009a), while others confirm findings that show reverse results (Peng et al., 2008a).
To introduce this discussion an asymmetric dynamic model is implemented first used by Banalieva et al. (2018), which combines institutional economics with the signaling theory. The model distinguishes between institutional market reforms and institutional market reversal and measures the change in these reforms to examine the change of firm performance. To identify institutional market reforms the heritage index of economic freedom is used. This index ranks countries on different dimensions of economic freedom, e.g. property rights, tax burden and investment freedom. The dimensions together are averaged each year in an overall score for all countries. As described on the Heritage index website “economic freedom is the fundamental right of every human to control his or her own labor and property”. In an economically free society, individuals are free to work, produce, consume and invest in any way they please. Governments allow the free movement of capital and goods, and avoid the constraint of liberty (“2020 Heritage index of Economic Freedom: About the index”, https://www.heritage.org/index/about).
4 U.S., while “Latin America” often is used to describe the most southern part of the Americas (Aguilera et al., 2017). The different colonial history can partly explain the why it is poorer and less developed than North America, there are still significant economic differences between countries within the region. For example, Argentina reached European levels of development in the 19th century before going through an extreme decline and Brazil which besides being unstable still continues to develop through the years. Latin America is a region with clearly shared features like the shared colonial history and the presence of natural resources, but also one with significant differences in terms of economic development, income equality and political structure (Bethell, 1995).
Since the late 1980 and early 1990 Latin American countries have seen an increase in international trade. Several regulations initiated during this period, like an increase in capital liberalizations magnified the economic openness of the region. The substantial increase of the exports in the Latin American countries exhibit a significant increase in economic growth during the period (Bekaert et al, 2006). An economic integration network, the Mercosur, was created during this period to improve the economic and monetary relations between Argentina, Brazil, Paraguay and Uruguay. However this integration process was slowed down due to the currency devaluation and sovereign debt default in Argentina and the currency crisis and subsequent devaluation in Brazil during the early 1990’s (Diamandis et al, 2011). Today Latin American companies appear with limited frequency in management research and are underrepresented into academic management literature (Brenes et al., 2016). An explanation is that Only a few Latin American firms are ranked into the list of largest most valuable firms in the world. In the Forbes edition of 2016 ranking of 2000 most valuable companies in the world only 62 originate from the region and in research focusing on emerging economies Latin American firms have a relatively low presence (Vassolo et al., 2011).
5 increasing. Figure 2 displays a significant difference between the specific countries. In the overall score Chile has a high overall freedom score over the sample period, while Argentina displays inferior results. Appendix 1, table 2 supplements these results, from which can deduced that Chile has a high score in all different components during the sample period and Argentina has an equal negative score. The difference between countries shows that although the countries are located in the same region, there are still underlying factors that need to be accounted for when analyzing the region as a whole.
The paper will be structured as follows. First, the literature review section will provide a theoretical background for institutional economics and displays how institutions have affected the Latin American region through history. Secondly, the methodology section explains the asymmetric dynamic approach model which is used to examine the effect of the change in degrees of economic freedom on firm performance. Finally a sensitivity analysis is conducted which examines the four biggest economies of Latin America (Brazil, Argentina, Chile and Mexico) separately.
Theoretical basis, literature review
Previous research in international business has used the institutions based view to show that the institutions are the humanly devised constraints that shape human interaction. Firms need to formulate and implement a strategy based on the institutions in place. Therefore, the way institutions are changed and influence firms are a central part of new institutional research (Ingram and Silverman, 2002). North (1992) argues that institutional economics influence the economic performance of firms by determining their transaction and transformation costs. The
2013, 57.87 2004, 59.66 57.60 57.80 58.00 58.20 58.40 58.60 58.80 59.00 59.20 59.40 59.60 59.80 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 Deg ree s o f E co n o m ic Fre ed o m Years Latin America
Figure 1: Degrees of Economic Freedom Latin America, overall score
Figure 2: Degrees of Economic Freedom countries Latin America, overall score
35.00 45.00 55.00 65.00 75.00 85.00 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 D eg re es o f Ec o no m ic Fr ee do m Years
Latin America Argentina Brazil
6 signaling theory argues that the rate of how a new institution is introduced may show governments future intentions and act as a signal to firms (Rodrik et al., 1989).
Institutional economics
The theory of institutional economics argues that the government is mainly responsible for the pro-market institutions that provide a framework which reduces transaction costs. Pro-market institutions provide a various set of rules for firms to change their performance. Property rights protection and contract dispute mechanics reduce the risk of exchange, while the set of rules of entry ensures the quality of exchange partners. Profit incentives motivate the exchange partners to fulfill the agreements. This will help the firm to improve their exchange and increase their performance (North 1992). Other research shows that legal institutional conditions affect the corporate governance of a firm, which ultimately leads to a different allocation of firm resources (Aguilera & Jackson, 2003). Firms that operate in countries that have fully developed pro-market institutions are more likely to develop corporate governance that is transparent, which in turn leads to a more efficient resource allocation and higher firm performance (La Porta et al. 2000).
In recent years signaling game logic is applied to many fields of international politics. The essence of the signaling game is that it implies that a state is a unitary actor with a single set of assumptions and preferences (Walsh, 2007). The signals provided by governments are a consensus of different kinds of interest groups that signal the outcome of the winning coalition. To prevent exposure to decreasing voting rates through the electoral process governments often try to send consistent credible signals (Fearon, 1994). Firms form their strategy by observing the consistency of the macroeconomic environment of a country. Managers will form their beliefs in response to governmental policy choices and consistency of those policies. Therefore, policy changes influence the business strategy of firms and thus, their performance (Walsh, 2007).
Institutional change
7 However, the early stages of change in emerging economies often fail to produce results at first due to the high risk and uncertainty of these changes. Therefore, the changes implemented by emerging economies often were less radical (Roland, 2011). In the short run informal institutions are harder to change than formal institutions, because beliefs and culture are much more persistent to change (North, 1990). The clash between formal and informal institutions in the short run will lead to a period of friction, which eventually is disrupted by a crisis, which in turn leads towards more pro-market reforms (Gersick, 1991). After a crisis, the old institutions norms and practices are often critizised and the public opinions shifts to more pro-market institutions. Once the institutional friction is resolved, an emerging government can gain legitimacy to pursue further pro-market institutional changes, eventually leading to the second period of institutional change; institutional convergence (Johnsen et al, 2000).
Cross-country analysis of pro-market reforms and firm performance
The two dimensions of pro-market institutional reforms are economic liberalization and the improvements of national governance (Fukuyama, 2004). Economic liberalization refers to the cutback of government activities in the market. This retrenchment allows private firms to attend economic relationships more efficiently. Examples are the increase in freedom that includes the increase of trade liberalization, FDI liberalization and privatization of firms. National governance improvements are adopted to raise government oversight to facilitate market operations and to limit the effects of misconduct. This will improve the law and order, regulations and infrastructure necessary to reduce market imperfections and improve economic activities (Williamson, 2004).
8 a lack of government credibility to sustain pro-market reforms, negatively affecting the firm performance (Yago & Morgan, 2008).
Bengoa et al. (2003) researched the relations among economic freedom, FDI and economic growth in South American countries by using both the Heritage Index and the Fraser institute index. They observed an overall growth of economic freedom among the 1970-1990 sample. Governments should strive to achieve a sound degree of political and economic freedom, together with a market oriented environment. By increasing the market liberalization economic growth can be achieved in a country, internal by the more stable market environment and externally by the increase of FDI.
Institutional reforms in Latin America
9 American countries. This cycle repeated itself for different products and at different points in time (Aguilera et al., 2017).
After World War II the economic situation in Latin America changed, the export-led growth model, previously used, was replaced by the import substitution industrialization (ISI). The ISI model uses export revenues to finance the domestic industrialization (Haar et al., 1995) instead of using the export revenues themselves. The model generated economic growth in the region, but also made the Latin American countries more diversified. The model relied on the size of the domestic economies, which made the model more successful in the larger countries, like Brazil. The countries failed to generate enough tax revenues to finance their own industrialization, that is why the industrialization largely depended on external financing. This made the countries vulnerable to external financial havoc. Thus, when the interest rate in western countries increased in 1979 the debt of Latin American countries became unpayable. The result was a decade of banking and currency crises, civil wars and hyperinflation (French-Davis, 2000)
10 public sector investment, which in these countries accounted for the largest share of economic activities. The decrease of foreign direct investment by 12% in Brazil, made it enter one of the worst recessions in history, which generated a political crisis (Rapoza 2015).
As the history of Latin American institutions shows, the region provides a unique sample for studying the several dimensions of macroeconomic context which shape the way domestic and international firms develop and react to risk and institutional change(Cuervo-Cazurra, 2016). Understanding how firms based in highly unstable environments manage risk could provide an interesting insight and provide further evidence of how the signalling theory is implemented in developing economies.
Research question and hypotheses
The asymmetric dynamic approach
The paper uses an asymmetric dynamic approach model first used in Banalieva et al. (2018). This model provides guidelines to distinguish between pro-market reforms and reversals. The model argues that different kind of institutional pro-market reforms can affect firm performance in different ways. Four kinds of pro-market institutional dynamic trends are distinguished: Intensifying pro-market reforms, Fading pro-market reforms, Intensifying pro-market reversals and Fading pro-market reversals.
Pro-market reforms are an improvement of the market institutions over time and the pro-market reversals are a deterioration of pro-pro-market institutions over time. Furthermore, intensifying effects, which are effects that continue at an increasing pace over time, and fading effects, which implies a continuing but fading effect over time, are distinguished (Figure 3).
H1d - H1c - H1b + H1a + Firm performance Fading reversals Intensifying reforms Intensifying reversals Fading reforms
11 This paper suggests that intensifying reforms not only positively influence the firm performance, but also fading reversals. When current market restricting reversals are fading managers expect the transaction cost to decrease. This will make companies invest more heavily in endeavors, which will increase their profit. On the contrary intensifying reversals not only negatively influence firm performance, but also fading reforms. Managers will expect transaction costs to increase and are likely to withhold on planned investment which will influence the firm performance. This reasoning results into four different hypotheses. The hypotheses will be discussed in order of expected impact on firm performance: intensifying reforms, fading reversals, fading reforms and intensifying reversals (Banalieva et al. 2018)
Intensifying pro-market reforms and firm performance
According to the signaling theory, to stay credible as a government it is expensive to reverse intensifying pro-market institutional change. When a country would reverse its pro-market reforms it will be expensive for firms and they will not be able to commit into long term investment. Firms expect that the current pro-market institutional trend persists and adjust their business strategy accordingly. Managers have confidence in the future direction of the economy and undertake more long-term investments. Firms can invest into more risky specific assets, which despite being more expensive can be depreciated over a longer amount of time. A greater lifting of government restrictions generates confidence for domestic firms, which are able to enter new sectors in which they were not expected to enter at first. The intensifying pro-market reforms also signals to the country that the government commits in further protecting investor freedom and the protection of property rights. Government expropriations and hold ups are reduced, which increases the return on investment.
The intensifying market liberalization can both have in-and-out flow effects. Inflow effects will occur when foreign or domestic competitors enter the domestic market, because of the lower barriers of entry (Narula et al., 2010). In Latin American countries the increasing market liberalization might open the door for Western companies to enter the domestic market. The outflow occurs when current players in the market are unable to withstand the increase in competition due to the market liberalization (Kumaraswamy et al., 2012). Still the overall effect of the increased market liberalization on firm performance is expected to be positive. The information above derives the following hypotheses:
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Fading pro-market reversals and firm performance
Fading pro-market reversals suggest a decreasing grip of the government over the economy. Firms expect this to be a positive signal from the government and may handle accordingly. This signal will build some confidence for the managers and make them act accordingly by committing into smaller-scale investments. As governments decrease their enforcement on foreign competition, firms must counter the increase in foreign competition by innovating their current product line with new inventive products. When foreign Western competitors enter the market the competition for Latin American firms increases significantly. To counter these external competitors, domestic firms need to commit to using their home advantage to keep their current market share. The reduction also reduces the concern around contract dispute mechanisms, and in turn will decrease the possible opportunism by exchange partners. These ideas support the following hypothesis:
Hypothesis 2: Fading pro-market reversals positively affect the firm performance in Latin American countries
Fading pro-market institutional change and firm performance
Fading pro-market reforms are interpreted as a weak negative signal from the government. The managerial confidence for future economic growth is likely to decrease and managers will be more weary to commit into appropriate strategic investments, while the transaction costs will increase (e.g. renegotiating existing contracts that no longer apply in the more negative environment). Managers tend to weigh negative information more heavily than positive information when evaluating their strategic alternatives (Baumeister et al. 2001). The potential costs of an investment are more heavily evaluated than the potential gain and managers of Latin American companies will be less likely to invest into long-term opportunities, such as company expansions or R&D projects. The postponement of said investments will increase the likeliness of inefficient operations, because they will be conducted with outdated equipment and product lines (Yago et al., 2008). The increase in uncertainty over future economic growth and the decrease in firm confidence drives the following hypothesis:
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Intensifying pro-market reversals and firm performance
Bad information tends to be stronger than good information, which has been shown on a broad range of psychological phenomena (Baumeister et al. 2001). Intensifying pro-market reversals are a sequence of negative government measures that predict the future state of the country’s economy. This sequence will lead to a comparable sequence of bad outcomes for firms. Therefore intensifying reversals will decrease the firm performance in Latin American economies the most. Transaction costs will increase and managers will implement strategies, which tend to avoid future losses.
The continued negative communication from the government will deepens the conviction of managers that the economy will eventually further deteriorate and critically constrain the long-term investments needed to improve the firm’s profitability in the long run. Intensifying reversals could also be a sign that the government could threaten property rights, thus leading to an decrease of investment for fear that the investments will be expropriated by the government. Governments might demand the employment of more workers to meet the governmental employment standards or to sell much of their production to the state below the market price. The above mentioned ideas are summarized in the following hypothesis.
Hypothesis 4: Intensifying pro-market reversals negatively influence the firm performance in emerging economies.
Methodology
Data source and sample
14 Heritage index of economic freedom and country specific data from the World development indicators (Issued by the World Bank).
Variables and Measures Firm performance
Following previous studies the paper considers the yearly percentual difference in the return on assets (ROA), winsorized at the 10% level, as a verified measure for firm performance (Kim et al. 2004, Daniels et al., 1989). The return on equity (ROE) and Tobins’q are disregarded, because most of the firms are not publicly listed.
Pro-market reforms
The Heritage index of economic freedom is applied to collect pro-market reform data of countries in Latin-America. The overall score of the index is the average of other categories:
Limited government (Government spending and Tax burden), Regulatory efficiency (Monetary
freedom and Business freedom), Open markets (Trade freedom, Investment freedom and Financial freedom) and Rule of law (Property rights and Government integrity). All the components are considered equally important, each freedom is weighted equally when determining the country scores. The categories are ranked from zero to one hundred, where zero suggests a low score on Economic freedom and a score of one hundred indicates more developed pro-market reforms in a year. In line with the research of Banalieva et al. (2018), this index is used to create two different categories pro-market reforms and pro-market reversals. Again these categories are divided into subcategories, namely “intensifying” and “fading”. The final dataset therefore consists of four categories defining pro-market reforms: Intensifying
reforms, fading reforms, intensifying reversals and fading reversals.
15 reforms. To be more specific, reforms are shown by the index, when the sum of the year-on-year changes over two consecutive periods is larger than zero (lag1+lag2>0). Reversals are shown if the sum is smaller than zero (lag1+lag2<0). Intensifying reforms or reversals are categorized as such, when the change between year 1 and year 0 is larger than the change between year 1 and year 2 (lag1 >= lag2). When a reform/reversal in the previous period is followed by an even larger reform or reversal in the consecutive period. Fading reversals or reforms are shown when the change is smaller (lag1 < lag2) or when the reform or reversal in the prior year is followed by a smaller reform reversal in the current period.
Control variables
To regulate the alternative influences on firm performance and country-level effects, several control variables are implemented into the research. For the firm performance the study controls for Firm Age, Firm Size, Leverage and marketing intensity. Firms that are larger might be more profitable than smaller firms, therefore the natural logarithm of the firms revenue is included into the dataset. Older firms might be more profitable and have generated more respect in the countries they operate. To account for this, a variable consisting of the natural logarithm of the number of years since the founding of the company plus 1 is inserted into the equation. Some firms in the dataset are founded during the sample period, generating negative values. For the negative values the number 1 is inserted, giving the value 0 (Ln(1)=0) which will not influence the regression. Leverage is used to control for the fact that firms with greater debt may be more pressured to pursue short term strategies which provide a certain profit from which they can cover their liabilities. The leverage variable is calculated by dividing the total debt by the total assets. Firms that produce brands that are more well known in countries, might perform better. To monitor this the variable Marketing Intensity is inserted which is calculated by dividing a firm’s general and administrative expenses by its total revenue.
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Statistical analysis
To determine whether a fixed effects or a random effects model should be used, a Hausman test is conducted. The Hausman test (0.000) supports the use of fixed effects. The following formula is constructed to test for the effect of the pro-market reforms on firm performance, where the specification “i” stands for firm, “c” for country and “t” for year.
𝑃𝑒𝑟𝑓𝑜𝑟𝑚𝑎𝑛𝑐𝑒𝑖+𝑡 = 𝛽1∗ 𝐼𝑛𝑡𝑒𝑛𝑠𝑖𝑓𝑦𝑖𝑛𝑔 𝑟𝑒𝑣𝑒𝑟𝑠𝑎𝑙𝑠𝑐,𝑡+ 𝛽2 ∗ 𝐹𝑎𝑑𝑖𝑛𝑔 𝑟𝑒𝑣𝑒𝑟𝑠𝑎𝑙𝑠𝑐,𝑡+ 𝛽3∗
𝐼𝑛𝑡𝑒𝑛𝑠𝑖𝑓𝑦𝑖𝑛𝑔 𝑟𝑒𝑓𝑜𝑟𝑚𝑠𝑐,𝑡+ 𝛽4∗ 𝐹𝑎𝑑𝑖𝑛𝑔 𝑟𝑒𝑓𝑜𝑟𝑚𝑠𝑐,𝑡+ 𝛽𝑖∗ 𝐹𝑖𝑟𝑚 𝑐𝑜𝑛𝑡𝑟𝑜𝑙𝑠𝑖,𝑡+ 𝛽𝑐 ∗
𝐶𝑜𝑢𝑛𝑡𝑟𝑦 𝑐𝑜𝑛𝑡𝑟𝑜𝑙𝑠𝑐,𝑡−1+ 𝑓𝑖 + 𝑦𝑡+ 𝑒𝑟𝑟𝑜𝑟𝑖,𝑡
Results
Descriptive statistics
VARIABLES N Mean STD Min Max
R.O.A. 13,290 0.0233 0.0973 -0.513 0.342 Firm Age 13,290 3.548 2.013 0 7.610 Net F.D.I. 13,290 0.0419 0.0311 0.0010 0.177 Market Size 13,290 9.087 0.428 7.538 9.624 Firm Size 13,290 11.52 9.345 0 23.35 Market intensity 13,290 0.158 0.310 0 2.468 Leverage 13,290 0.544 1.126 0 2.168 Export value 13,290 25.28 0.982 22.32 26.80 GDP change (%) 13,290 0.0342 0.0314 -0.0529 0.0987
17 Variables (1) (2) (3) (4) (5) (6) (7) (8) (9) R.O.A. 1.000 Firm Age 0.029* 1.000 Net F.D.I. 0.049* -0.118* 1.000 Market Size -0.035* 0.056* 0.066* 1.000 Market intensity -0.077* 0.005 0.011 0.094* 1.000 Firm size Leverage Export value GDP change (%) 0.229* -0.087* -0.036* 0.050* 0.102* 0.003 0.098* -0.105* 0.058* 0.031* -0.163* 0.155* 0.210* 0.083* 0.585* -0.270* 0.303* 0.068* 0.034 -0.045* 1.000 0.246* 0.145* -0.139* 1.000 0.057* -0.054* 1.000 -0.198* 1.000
18 Table 1 provides the descriptive statistics of the raw data variables. After winsorizing to the 10% level, the variables show the following statistics. The yearly difference in the return on assets has a low mean (0.0233) and standard deviation (0.0973) which suggests little changes within the firms over the sample period. The variable Firm Age demonstrates with a considerable standard deviation (2.013) an extensive variety in the maturity of the firms in the sample. The variable Firm Size also suggests a large variety in the size of firms present in the sample. Table 2 shows the correlation matrix of the used variables. A significant correlation between two different variables could suggest multicollinearity in the sample, which makes that the independent variables are no longer independent. The table demonstrates which correlations are significant on the 5% level. Firm Size has a relative high correlation with all the other control variables, the correlation between Firm Size and Market intensity being the more considerable (0.303). Some correlations can be accounted for, e.g. a change in the Firm Size will automatically increase its market intensity. The collinearity of leverage with Firm Size is something that has to be noted. Apparently there is a high correlation between the size of firms and the level of debt (0.246), this relation could influence the results and can result into multicollinearity.
Hypotheses testing
Table 3 presents the results of the overall score analysis, which are the results for the whole dataset. In the appendix the results of the separate components (Rule of Law, Limited Government, Regulatory Efficiency and Open Markets) are displayed.
Supported hypotheses
The results show support for the direct effect of pro-market institutional changes on firm performance. Table 3 shows the effect of the Economic freedom score, the average of all different components, on firm performance. The overall score results support both the results of hypotheses 1 and 2. Hypotheses 1 is supported by the evidence of the positive (0.0198) and significant (p < 0.01) coefficient of the intensifying reforms. Hypothesis 2, regarding the fading reversals, is supported by the results in table 3, which are positive (0.0123) and significant (p
< 0.01). The results of the components in Appendix B, show that the components Limited
19 Hypothesis 2 is supported by the results of the components Limited Government (0.0139), Regulatory Efficiency (0.0149) and Open Markets (0.0112) also back up the hypothesis.
Unsupported hypotheses
In the overall score results the paper does not find direct evidence for the support of the hypotheses 3 and 4. The fading reforms hypothesis shows positive (0.0227) and significant (p
< 0.01) results, which is opposite to the predicted direction. Hypothesis 4 also demonstrates
positive (0.0173) and significant (p < 0.01) outcomes, which counter the original projections. The results in Appendix B also provide no significant results which can support hypothesis 3 and 4. These results suggest that managers of firms in the Latin American countries do not interpret the fading reforms or intensifying reversals as a negative signal and think lightly of the influence the fading reforms or intensifying reversals have on their firms. Possible explanations for this are, that managers are used to the unstable institutional climate and do not adjust their business strategy according to government regulations or the performance of the firms is not determined by the pro-market institutional reforms of the country where the firm’s headquarters is located.
Sensitivity Analysis
The results of the sensitivity analysis (Appendix C) provide an insight in the different countries used to create the overall score. For the analysis the countries Argentina, Brazil, Chile and Mexico are examined individually on the same components of the heritage index. The four countries are selected, because they are the major economies in the Latin American region and economic development which takes place in these countries also have a substantial impact on the other Latin American countries. Nonetheless do they still differ in degree of development, rate of growth and size of the economy (Diamandis et al., 2011).
20 positive (0.0418 and 0.0259) and significant effect (p > 0.01), which contradicts the stated hypotheses 3 and 4
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Model 1 Model 2 Model 3
VARIABLES R.O.A. R.O.A. R.O.A.
Intensifying reforms 0.0198*** 0.00730*** (0.00328) (0.00168) Fading reforms 0.0227*** 0.00913*** (0.00384) (0.00239) Intensifying reversals 0.0173*** -0.00118 (0.00354) (0.00204) Fading reversals 0.0123*** -0.00485*** (0.00313) (0.00159) Firm age -0.0119*** -0.0116*** -0.0118*** (0.00239) (0.00240) (0.00240) Net F.D.I. -0.0424 -0.0146 0.00295 (0.0522) (0.0515) (0.0517) Market Size 0.00346 0.0187** 0.0229*** (0.00829) (0.00768) (0.00771) Market Intensity -0.0461*** -0.0464*** -0.0465*** (0.00314) (0.00314) (0.00315) Firm size 0.00347*** 0.00350*** 0.00353*** (0.000164) (0.000164) (0.000164) Leverage -0.0117*** -0.0118*** -0.0119*** (0.000755) (0.000755) (0.000756) GDP growth (%) 0.105*** 0.0898*** 0.0815*** (0.0249) (0.0247) (0.0246) Export Value 0.0160*** 0.0169*** 0.0173*** (0.00251) (0.00251) (0.00251) Constant -0.418*** -0.568*** -0.613*** (0.110) (0.106) (0.106) Observations 13,290 13,290 13,290 R-squared 0.066 0.064 0.063 Hausman test 0.000 0.000 0.000 Number of companies 886 886 886
Discussion
Table 3 presents the effect of the overall institutional pro-market changes on the firm performance in Latin American countries. The dependent variable R.O.A. is defined as the yearly percentual difference of the return on assets. The variable is defined as Intensifying reformst-1 when the change of the index between years is more positive in the second
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Theoretical implications
The topic of this study, the impact of pro-market institutional change on firm performance in Latin American countries is part of an important debate on the effect the government has on firms. Pro-market reforms have over the course of time proven to be beneficial for most countries across the world (Yergin & Stanislaw, 1998). However governments often change their policy direction between pro-market reforms and reversals, depending on the current political direction of the government. This paper provides a new dimension in the research towards pro-market reforms by solely examining companies from the Latin American region that is characterized by unstable governments and macroeconomic policies (Taylor, 1998). The wavering between reforms and reversals causes insecurity for the strategic course firms need to follow. The paper itself provides two additions to the literature.
The first contribution to the theory is the effect of a change country pro-market institutions on firm performance. This part of theory contributes to the institutional theory which analyse the effect of institutional changes on firm behaviour and performance. Previous research shows the positive effect of pro-market reforms on the profitability of state-owned firms, domestic firms and subsidiaries of foreign firms (Cuervo-Cazurra et al, 2009). However previous literature often confuses the change of pro-market institutions with pro-market reforms, which implies that institutional change always adjusts towards intensifying reforms. This paper uses an asymmetric dynamic approach (Banalieva et al., 2018) by distinguishing between pro-market institutional reforms and reversals and the pace of the institutional change (intensifying of fading). By implementing this model the different types of signals a managers can experience and the effect on the expectations managers have of the institutional environment are accounted for.
The second contribution of this paper is on the front of implementing the signalling theory more intensively, by regarding the expectation of managers for their companies according to the institutional change. The signal the government provides is important, because it affects the firms profitability, the transaction costs a firm experiences and the long-term investment a firm plans to commence in. Managers perception of the economic growth of a country is important for the strategic business plan they wish to implement in the company.
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Limitations
The paper establishes a link between the pro-market institutional change and the firm performance in Latin American countries. This part highlights the most important irregularities and limitations encountered during the research.
During the construction of the paper the accessibility of the data for Latin American countries was often not sufficient. The paper used the dataset of Eikon Thomson Reuters for the collection of data, however the data was inconclusive for several firms depending on the originating country. When constructing the dataset important variables, as foreign sales and R&D expenses, were not available. The ratio foreign sales to total sales is often used to measure multinationality in international business literature (Haar, 1989). Multinationality is in the literature often regarded as international diversification or expansion and is usually defined as how much of a firm’s operation are spread across international borders (Contractor et al., 2007). Multinationality is an important factor when measuring firm performance. When a firm’s operations are more international diversified, the performance could be less reliant on the pro-market institutional change in the domestic country (Banalieva et al., 2018). Therefore, an addition of international diversification into the model is necessary to account for this feature. Several steps were undertaken to implement the international diversification of firms into the model, but unfortunately the results were still inconclusive. In this paper most of the firms are not publicly listed, therefore the effect of international diversification can mostly be discarded. However, when future research wants to examine the effect of the pro-market institutional change on the firm performance of publicly listed firms or MNE’s, multinationality can be added to the model.
24 excluded. Future research could acquire more information on these factors and examine the effect of each individual component on firm performance.
Latin America is a region which traditionally suffered from economic and political uncertainty. Most firms originating from the region are family owned businesses often organized in pyramidical groups with complex accountability and control structures. The firms were often previously owned by the government before being privatized (Aguilera et al, 2017). The family owned business structure of Latin American firms influences the reaction process of firms to pro-market institutional change and, while providing unique results, does not provide sustainable evidence for other regions. Therefore future research can centralize different regions or focus on country specific effects by increasing the firm sample size.
Conclusion
The paper examines the relationship between the pro-market institutional change in a country and the firm performance. Latin America provides an unique geographical area in which the social political and macroeconomic environment shape the type of firms that operate in the region. The empirical results show the positive influence of intensifying pro-market reforms on the firm performance in countries from the Latin American region. These results are in line with the results of previous research which examined the effect of institutional pro-market changes on the firm performance in emerging economies (Banalieva et al., 2018) and the effect of pro-market reforms on multinational corporations in emerging economies (Dau, 2009).
25 managers in their long term investment business strategy which indirectly influences the firm performance.
The sensitivity analysis examines the effect of pro-market institutional change on firm performance in four of the biggest economies in Latin America; Brazil, Argentina, Chile and Mexico. Most of the results supplement the results derived from the whole sample. There are significant positive effects for all four pro-market change directions in the countries Brazil, Argentina and Chile. These results are in line with hypotheses 1 and 2 while contradicting hypotheses 3 and 4. There were no significant results found in the Mexico sample, which underlines the difference present between the countries represented in Latin America.
26
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Appendix
31
Appendix B
Table B1 Effect of Rule of Law on Firm performance
Model 1 Model 2 Model 3
VARIABLES R.O.A. R.O.A. R.O.A.
Intensifying reforms 0.000477 -0.00280 (0.00259) (0.00182) Fading reforms 0.00418 0.000915 (0.00300) (0.00231) Intensifying reversals 0.00300 0.00155 (0.00291) (0.00224) Fading reversals 0.00435* 0.00326** (0.00226) (0.00158) Firm age -0.0120*** -0.0120*** -0.0119*** (0.00240) (0.00240) (0.00240) Net F.D.I. 0.0557 0.0470 0.0623 (0.0524) (0.0521) (0.0520) Market Size 0.0242*** 0.0249*** 0.0257*** (0.00779) (0.00775) (0.00766) Market Intensity -0.0463*** -0.0465*** -0.0463*** (0.00315) (0.00315) (0.00315) Firm size 0.00351*** 0.00352*** 0.00351*** (0.000164) (0.000164) (0.000164) Leverage -0.0118*** -0.0119*** -0.0118*** (0.000757) (0.000756) (0.000756) GDP growth (%) 0.0894*** 0.0855*** 0.0819*** (0.0255) (0.0248) (0.0249) Export Value 0.0181*** 0.0179*** 0.0175*** (0.00254) (0.00254) (0.00251) Constant -0.652*** -0.650*** -0.649*** (0.105) (0.105) (0.105) Observations 13,290 13,290 13,290 R-squared 0.064 0.062 0.062 Hausman test 0.000 0.000 0.000 Number of companies 886 886 886
Table B1 presents the effect of the Rule of Law institutional changes on the firm performance in Latin American countries. Rule of Law accounts for the changes in the property rights protection and government integrity in a country. The dependent variable R.O.A. is defined as the yearly percentual difference of the return on assets. The variable is defined as Intensifying reformst-1 when the
32
Table B2 Effect of Limited government on firm performance
Model 1 Model 2 Model 3
VARIABLES R.O.A. R.O.A. R.O.A.
Intensifying reforms 0.0165*** 0.00462*** (0.00303) (0.00150) Fading reforms 0.0140*** 0.00246 (0.00403) (0.00312) Intensifying reversals 0.0120*** -0.00221 (0.00336) (0.00208)
Fading reversals 0.0139*** -6.51e-05
(0.00301) (0.00154) Firm age -0.0123*** -0.0122*** -0.0121*** (0.00240) (0.00240) (0.00240) Net F.D.I. 0.00662 0.0265 0.0246 (0.0525) (0.0514) (0.0517) Market Size 0.0124 0.0241*** 0.0258*** (0.00820) (0.00762) (0.00783) Market Intensity -0.0462*** -0.0464*** -0.0465*** (0.00314) (0.00315) (0.00315) Firm size 0.00349*** 0.00351*** 0.00352*** (0.000164) (0.000164) (0.000164) Leverage -0.0118*** -0.0119*** -0.0118*** (0.000756) (0.000756) (0.000756) GDP growth (%) 0.101*** 0.0821*** 0.0853*** (0.0250) (0.0246) (0.0248) Export Value 0.0183*** 0.0190*** 0.0182*** (0.00252) (0.00252) (0.00253) Constant -0.557*** -0.669*** -0.664*** (0.109) (0.105) (0.108) Observations 13,290 13,290 13,290 R-squared 0.064 0.062 0.062 Hausman test 0.000 0.000 0.000 Number of companies 886 886 886
Table B2 presents the effect of the Limited Government changes on the firm performance in Latin American countries. Limited government accounts for the changes in Government spending and Tax burden in a country. The dependent variable R.O.A. is defined as the yearly percentual difference of the return on assets. The variable is defined as Intensifying reformst-1 when the change
33
Table B3 Effect of Regulatory effects on firm performance
Model 1 Model 2 Model 3
VARIABLES R.O.A. R.O.A. R.O.A.
Intensifying reforms 0.0149*** 0.00186 (0.00321) (0.00161) Fading reforms 0.0176*** 0.00423* (0.00365) (0.00226) Intensifying reversals 0.0145*** 0.000226 (0.00348) (0.00199) Fading reversals 0.0149*** 0.00118 (0.00319) (0.00158) Firm age -0.0124*** -0.0123*** -0.0120*** (0.00240) (0.00240) (0.00240) Net F.D.I. 0.0134 0.0182 0.0412 (0.0513) (0.0514) (0.0510) Market Size 0.0100 0.0241*** 0.0233*** (0.00825) (0.00764) (0.00783) Market Intensity -0.0462*** -0.0464*** -0.0465*** (0.00314) (0.00315) (0.00315) Firm size 0.00347*** 0.00351*** 0.00352*** (0.000164) (0.000164) (0.000164) Leverage -0.0117*** -0.0118*** -0.0118*** (0.000756) (0.000756) (0.000756) GDP growth (%) 0.0951*** 0.0777*** 0.0859*** (0.0251) (0.0248) (0.0248) Export Value 0.0179*** 0.0190*** 0.0177*** (0.00255) (0.00255) (0.00254) Constant -0.526*** -0.667*** -0.629*** (0.110) (0.106) (0.108) Observations 13,290 13,290 13,290 R-squared 0.064 0.062 0.062 Hausman test 0.000 0.000 0.000 Number of companies 886 886 886
Table B3 presents the effect of the Regulatory effect changes on the firm performance in Latin American countries. Regulatory effects accounts for the change in Monetary freedom and Business freedom in a country. The dependent variable R.O.A. is defined as the yearly percentual difference of the return on assets. The variable is defined as Intensifying reformst-1 when the change of the
34
Table B4 Effect of Open Markets on Firm performance
Model 1 Model 2 Model 3
VARIABLES R.O.A. R.O.A. R.O.A.
Intensifying reforms 0.0170*** 0.00757*** (0.00276) (0.00159) Fading reforms 0.0105*** 0.000627 (0.00303) (0.00190) Intensifying reversals 0.0120*** -0.000573 (0.00345) (0.00255) Fading reversals 0.0112*** -0.00121 (0.00275) (0.00150) Firm age -0.0122*** -0.0116*** -0.0120*** (0.00240) (0.00240) (0.00240) Net F.D.I. 0.0427 0.0631 0.0386 (0.0512) (0.0508) (0.0509) Market Size 0.0164** 0.0226*** 0.0241*** (0.00788) (0.00770) (0.00765) Market Intensity -0.0463*** -0.0464*** -0.0465*** (0.00314) (0.00314) (0.00315) Firm size 0.00348*** 0.00352*** 0.00352*** (0.000164) (0.000164) (0.000164) Leverage -0.0117*** -0.0118*** -0.0118*** (0.000756) (0.000755) (0.000756) GDP growth (%) 0.0971*** 0.0853*** 0.0829*** (0.0247) (0.0246) (0.0246) Export Value 0.0171*** 0.0180*** 0.0180*** (0.00258) (0.00253) (0.00254) Constant -0.564*** -0.634*** -0.643*** (0.109) (0.107) (0.106) Observations 13,290 13,290 13,290 R-squared 0.064 0.062 0.062 Hausman test 0.000 0.000 0.000 Number of companies 886 886 886
Table B4 presents the effect of the Open Market changes on the firm performance in Latin American countries. Open markets accounts for the Trade freedom, Investment freedom and financial freedom in a country. The dependent variable R.O.A. is defined as the yearly percentual difference of the return on assets. The variable is defined as Intensifying reformst-1 when the change of the index
35
Appendix C Sensitivity analysis
Table C1 Effect of institutional change in Argentina
Model 1 Model 2 Model 3
VARIABLES R.O.A. R.O.A. R.O.A.
Intensifying reforms 0.0820*** 0.0211** (0.0188) (0.0106) Fading reforms 0.0862*** 0.0283** (0.0198) (0.0124) Intensifying reversals 0.0675*** -0.00233 (0.0174) (0.00920) Fading reversals 0.0579*** -0.00735 (0.0161) (0.00851) Firm age 0.000808 0.000520 0.000193 (0.00414) (0.00414) (0.00414) Net F.D.I. -0.236 -0.674 0.0418 (0.718) (0.622) (0.701) Market Size -0.0811 0.0481 0.0731* (0.0507) (0.0386) (0.0389) Market Intensity -0.0899*** -0.0913*** -0.0923*** (0.0121) (0.0121) (0.0122) Firm size 0.00534*** 0.00529*** 0.00529*** (0.000703) (0.000705) (0.000706) Leverage -0.0191*** -0.0186*** -0.0185*** (0.00297) (0.00299) (0.00299) GDP growth (%) 0.0114 0.0358 0.00960 (0.0928) (0.0851) (0.0893) Export Value 0.0549*** 0.0506*** 0.0354** (0.0187) (0.0181) (0.0151) Constant -0.714 -1.727*** -1.580*** (0.582) (0.515) (0.516) Observations 1,275 1,275 1,275 Hausman test 0.965 0.965 0.965 Number of companies 85 85 85
Table C1 presents the effect of the overall institutional pro-market changes on the firm performance in Argentina. The dependent variable R.O.A. is defined as the yearly percentual difference of the return on assets. The variable is defined as Intensifying reformst-1 when the change of the index between years is more positive in the second year compared to the change
36
Table C2 Effect of institutional change in Brazil
Model 1 Model 2 Model 3
VARIABLES R.O.A. R.O.A. R.O.A.
Intensifying reforms 0.0347*** 0.0108** (0.0111) (0.00481) Fading reforms 0.0418** 0.0115 (0.0171) (0.00776) Intensifying reversals 0.0259*** 0.00364 (0.00857) (0.00454) Fading reversals 0.0197** -0.00610* (0.00954) (0.00352) Firm age -0.0174*** -0.0180*** -0.0182*** (0.00490) (0.00490) (0.00490) Net F.D.I. 0.605 0.170 -0.427 (0.510) (0.336) (0.291) Market Size -0.128** -0.0456 0.00804 (0.0605) (0.0380) (0.0283) Market Intensity -0.0455*** -0.0459*** -0.0458*** (0.00634) (0.00634) (0.00634) Firm size 0.00423*** 0.00425*** 0.00424*** (0.000335) (0.000335) (0.000335) Leverage -0.0172*** -0.0172*** -0.0171*** (0.00152) (0.00152) (0.00152) GDP growth (%) 0.0997 0.0979 0.131** (0.0690) (0.0612) (0.0569) Export Value 0.0234** 0.0199*** 0.0116 (0.0101) (0.00729) (0.00711) Constant 0.560 -0.0730 -0.333 (0.409) (0.318) (0.270) Observations 4,170 4,170 4,170 R-squared 0.080 0.077 0.077 Hausman test 0.000 0.000 0.000 Number of companies 278 278 278
Table C2 presents the effect of the overall institutional pro-market changes on the firm performance in Brazil. The dependent variable R.O.A. is defined as the yearly percentual difference of the return on assets. The variable is defined as Intensifying reformst-1 when the change of the index between years is more positive in the second year compared to the change in the first
37
Table C3 Effect of institutional change in Chile
Model 1 Model 2 Model 3
VARIABLES R.O.A. R.O.A. R.O.A.
Intensifying reforms 0.0154** 0.00511 (0.00758) (0.00402) Fading reforms 0.0241** 0.0142** (0.0112) (0.00720) Intensifying reversals 0.0272*** 0.0134* (0.0103) (0.00775) Fading reversals 0.0108 -0.00611 (0.00881) (0.00439) Firm age 0.00378 0.00367 0.00360 (0.00275) (0.00275) (0.00275) Net F.D.I. 0.383*** 0.322** 0.412*** (0.139) (0.137) (0.138) Market Size -0.112*** -0.0742*** -0.102*** (0.0305) (0.0265) (0.0298) Market Intensity -0.0309*** -0.0311*** -0.0311*** (0.00548) (0.00548) (0.00548) Firm size 0.00251*** 0.00253*** 0.00253*** (0.000345) (0.000345) (0.000345) Leverage -0.00528*** -0.00546*** -0.00540*** (0.00149) (0.00149) (0.00149) GDP growth (%) 0.0805 0.141 -0.0580 (0.124) (0.113) (0.0851) Export Value -0.0577*** -0.0413** -0.0580*** (0.0180) (0.0170) (0.0180) Constant 2.452*** 1.697*** 2.387*** (0.679) (0.620) (0.679) Observations 2,340 2,340 2,340 Hausman test 0.945 0.945 0.945 Number of companies 156 156 156
Table C3 presents the effect of the overall institutional pro-market changes on the firm performance in Chile. The dependent variable R.O.A. is defined as the yearly percentual difference of the return on assets. The variable is defined as Intensifying reformst-1 when the change of the index between years is more positive in the second year compared to the change in the first
38
Table C4 Effect of institutional change in Mexico
Model 1 Model 2 Model 3
VARIABLES R.O.A. R.O.A. R.O.A.
Intensifying reforms 0.00415 -0.00215 (0.00779) (0.00383) Fading reforms -0.000884 -0.00847 (0.00935) (0.00643) Intensifying reversals 0.0394*** 0.0377*** (0.01000) (0.00867) Fading reversals 0.0109 0.00813** (0.00783) (0.00371) Firm age -0.00215 -0.00231* -0.00215 (0.00140) (0.00140) (0.00140) Net F.D.I. -0.245 0.178 -0.290 (0.355) (0.275) (0.305) Market Size 0.268** 0.0730 0.301*** (0.110) (0.0825) (0.0974) Market Intensity -0.0741*** -0.0750*** -0.0742*** (0.00677) (0.00680) (0.00677) Firm size 0.00377*** 0.00371*** 0.00377*** (0.000315) (0.000315) (0.000313) Leverage -0.00901*** -0.00940*** -0.00902*** (0.00166) (0.00166) (0.00165) GDP growth (%) 0.0545 0.0622 0.0324 (0.0848) (0.0752) (0.0777) Export Value 0.0881*** 0.0297** 0.0930*** (0.0212) (0.0142) (0.0200) Constant -4.801*** -1.459 -5.224*** (1.522) (1.094) (1.382) Observations 1,650 1,650 1,650 Hausman test 0.539 0.539 0.539 Number of companies 110 110 110
Table C4 presents the effect of the overall institutional pro-market changes on the firm performance in Mexico. The dependent variable R.O.A. is defined as the yearly percentual difference of the return on assets. The variable is defined as Intensifying reformst-1 when the change of the index between years is more positive in the second year compared to the change in the first
