Corporate governance in Central and Eastern Europe

The proposed project analyses the transition process in the Central- and Eastern European countries, mainly from the viewpoint of corporate governance reform. The major objectives of the project are as follows: (1) to set up of a unique data basis containing indicators at the firm level (ca. 10.000 firms over 10 years) on ownership structure, innovation, investment and merger activities, and balance sheets and market values. The time period is the beginning of 1990s until now. (2) To test various hypotheses on innovation and investment behaviour of firms, profitability and mergers/foreign direct investment. Many of these hypotheses cannot be tested in established Western economies, since the transition process provides a unique laboratory. The project will cast new light on key problems in both developed and transition economies. For example, the main criticism of ownership studies is the "endogeneity of ownership and performance". Economic transformation and therefore the change in the ownership structure involved (nearly) all firms, thus this problem can be addressed from a new angle. Empirical evidence on the innovation process in transition countries is rather scant and is constrained on issues of technology transfer from (predominantly Western) parent companies to their subsidiaries. Moreover, there is a certain inconsistency between studies and their assumptions from the fields of foreign direct investment and corporate governance. While the former assumes profit maximization of firms (and managers) and therefore ignores corporate governance problems, control failure in large firms is the very focus of corporate governance research.

In this project we analyze the post-communist transition process from a micro, i.e. corporate governance, perspective. We examine the performance of both parent firms and their subsidiaries in Central and Eastern Europe (CEE) and consider how the performance is influenced by various variables like the quality of government institutions and company ownership structure. For comparison purposes, we also extend the analysis to domestically owned firms and foreign subsidiaries in non-CEE countries. Our particular focus is on the investment behaviour and performance of CEE firms. There are several contributions of this research project to the existing literature. First, we examine the determinants of subsidiaries` profitability and find that the quality of country institutions and the country legal systems are generally associated with better performance. Our results are also consistent with the transfer of good corporate governance by the parent firm to its subsidiaries, since what matters most is the institutional quality of the country in which the parent firm is located. Second, we examine the determinants of the functioning of internal capital markets (ICMs) and reveal that company and country institutional structures matter. Ownership participation of the parent firm in the subsidiary plays a crucial role for the efficient functioning of ICMs. The best functioning cross-border ICMs can be found in the sub-sample of firms with parents from a country with `strong` institutions and subsidiaries from a country with `weak` institutions. Subsidiaries in Eastern Europe are more dependent on ICMs than subsidiaries elsewhere. Third, we study the determinants of investment behaviour estimating investment-cash flow models and find that investment-cash flow sensitivities decline over transition years. Ownership structures matter. For state owned firms, in early transition the investment-cash-flow sensitivity is negative, which we interpret as being consistent with soft budget constraints. Privatised firms invest efficiently. Foreign controlled firms are less financially constrained than other firms. Fourth, we examine the determinants of the ultimate ownership change in post-communist transition countries and find that greater efficiency in governmental institutions increased the likelihood of privatization. Fifth, we study the determinants of economic growth in transition countries and find that stronger economic freedoms lead to more rapid growth, but large public sectors and public deficits have adverse effects on growth. We identify trade freedom, monetary freedom and freedom from corruption as the most important indicators of economic freedom for growth in transition countries over the period 1994-2007. Sixth, we identify a variety of factors that have led to a bad governance in post-communist transition. Our results have policy implications for both policy on protection of foreign investors, stock market rules, the creation of domestic and foreign subsidiaries and the like, and broader issues like social and cultural cooperation in enlarged Europe.