STORY
2

 HOW DOES CORRUPTION AFFECT FIRM-LEVEL
FINANCIAL DECISIONS?

Corruption, especially
in the form of rent-seeking, is pervasive. Survey evidence indicates that
approximately 20% of firms around the world have experienced at least one bribe
request from a public official. These additional payments are often required to
obtain an operating license, import license, construction permit, government
contract, or other government action. Despite its pervasiveness, surprisingly
little is known about how this rent-seeking behavior affects firms and their
operation. Literally, corruption is acknowledged to be an international
phenomenon. They are especially found in emerging markets with underdeveloped
financial systems, weak legal protection of investors, and severe government
intervention. It’s also associated with political connection firm (PCF) where
at least one of its large shareholders (anyone controlling at least ten percent
of voting shares) or one of its top officers (CEO, president, vice-president,
chairman, or secretary) is a member of parliament, a minister, or is closely
related to a top politician or party (Faccio).

Two main, competing
theories on corruption have been developed. In one, corruption is efficient,
allowing firms to cut through bureaucratic rules quickly. In the other,
corruption is inefficient—likened to a more harmful form of taxation (Shleifer
and Vishny, 1993)—and it imposes losses on firms. The empirical literature is
somewhat mixed, as there is support for both theories. The tension between efficient
and inefficient corruption means that whether firms will pay or avoid bribes is
unclear. Through own study, Shleifer and Vishny (1993) provide two keys to build
up the level of corruption, including the structure of government institutions
and the political process. In particular, weak governments do not control their
agencies effectively. As a result, they experience very high levels of
corruption. This can be seen through international evidence as well. Fan et al.,
2009 confirm that political decentralization could impede coordination and
exacerbate incentives for officials to push the common bribe into higher level.

Through empirical
previous research papers, three potential sources of benefits from political
connection were pointed out, including: preferential access to credit, tax
discounts, and market power. Firms benefit by political connection to ease
financial restriction. Taking the advantages of three sources of political
connection benefit, firms then have higher leverage, lower tax rates and
greater market shares. Other researches also point out issue being relate to
political connection in firm-level. Faccio et al. (2006) provide that PCFs face
lesser impediment in case of shortfall. They are more likely than unconnected
firms to be bailed out by the government in case of financial distress. In
conclusion, he identify an additional direct channel through which connections
create value. Through an international event study, Boubakri et al. (2011) similarly
find that firm performance and leverage are related to political events. In
detail, they increase after the nomination of a politician on the board of
directors of publicly listed firms or after an executive enters politics. In
the same vein Boubakri et al. (2011) document that the political connection is
more valuable whenever the ties are closer to political power. This evidence is
also confirmed in study of Faccio (2006). 

Piotroski and Zhang
(2014) chose China market as a general market for their research. China is kind
of market that exhibits explicitly the influence of government control on
private entities. The government controls the key resources that are essential
for the corporate sector. In this sense, politicians can explicitly and
implicitly shape the incentives and decisions of economic entities, by directly
controlling the activity of state-owned enterprises (SOEs) through government
ownership, and indirectly controlling the behavior of non-SOEs through soft
channels (such as regulations, licenses, and social and political networks).

Ngo (2008) and Cai et
al. (2011) demonstrated that firm operates under government’s supervision.
Thus, in order to be treated preferentially by the government and gain a
competitive advantage, firms have strong incentives to stay close to the
government through bribing politicians or forming personal relationships in
exchange for contracts and opportunities for private illicit gains. This suggests
that, all else being equal, firms that benefit from political connections may
expand their investment activities.

Moreover, existing
theory showed by Duchin et al., 2010 predicts that corporate investment will be
hampered due to the lack of sufficient financing, which would be particularly
severe for financially constrained firms. Nevertheless, political connections
are effective in helping firms to overcome the disadvantages of these financing
constraints, and are significantly associated with more domestic financing or
higher levels of leverage (Leuz and Oberholzer-Gee, 2006; Claessens et al.,
2008; Li et al., 2008; Faccio, 2010; Piotroski and Zhang, 2014). Thus, close
connections with the government reduce their financial constraints and may
facilitate firms to invest more in financial decisions.

Xiaofei Pan, Gary Gang
Tian (2017) argued that the influence of political connections is expected to
be different for SOEs and non-SOEs. Their argument is consistent with the
theoretical framework proposed and discussed by Wu et al. (2012). In
particular, SOEs are naturally connected with the government through their
government ownership, and are more likely to be favored by the government in
terms of financing and investments (Brandt and Li, 2003). However, political
connections in SOEs do not provide additional benefits in the form of more
investment activities. Comparing to SOEs, non-SOEs generally get in trouble
with ideological discrimination against private ownership and the failure due
to lacking the bail of the government when the economic market is in distress.
Non-SOEs thus have strong incentives to cultivate and maintain close
connections with the government, which is helpful in overcoming these issues.
Li et al., 2008; Xu et al., 2011; Feng et al., 2015; Lin et al., 2016 provided the
conclusion that the political connections have been documented to be valuable
for non-SOEs in areas such as financing and investments. Study Li et al., 2008
in China also provided evidence that firms with political connections tend to
receive preferential treatment from state-owned banks and other financial
institutions. Faccio et al. (2006), using firm-level data from 35 countries,
moreover found that firms involving government officials are more likely to
receive financial assistance from the government when they are distressed.

Existing literature
validates how change in corruption affect the invest activities of SOEs and non
SOEs. Both SOEs and non-SOEs may reduce their respective investment
expenditures after the termination of political connections. In SOEs, if
managers have connections with government bureaucrats through bribery or
personal relationships, there is a potential for collusion between government
officials and SOE managers, because connected SOE managers have more incentives
to extract private benefits rather than to maximize shareholder value through
either bribery or personal relationships. In this circumstance, SOE managers
have stronger incentives for self-dealing behavior and pursuit of private benefits
(such as political promotion, perks and inflated compensation, or taking bribes
in the course of obtaining more investment projects). Moreover, in exchange for
this self-dealing behavior, SOE managers also need to satisfy government
officials and help in accomplishing social or political objectives that are not
necessarily in the best interests of minority shareholders but are preferred by
government officials. These causes, then, suggest that excessive investments in
SOEs are sub-optimal with low efficiency, and may not provide any additional
benefit to shareholders. In addition, soft budget lending resulting from
political connections may further exacerbate inefficient investment activities,
which in turn encourage these SOEs to invest more for personal objectives,
rather than for economic objectives (Zheng and Zhu, 2013). Once the potential
collusion or the political connections are terminated, the distorted investment
efficiency will be rectified, leading to improved investment efficiency. On the
other hand, unlike the case of SOEs, the dominant objective of non-SOEs is to
maximize shareholder value. Thus, non-SOEs are likely to be involved in
maintaining political connections only if those connections bring economic
benefits, including profitable investment opportunities.

Working in Indonesia
marketing, Jiangtao Fu et al. (2017) examine how firms’ political connections
affect their access to finance and performance. They determine individual firm’s
political connections by identifying whether the government owns shares in the
firm, whether politicians are on its board of directors, and whether
highly-ranked managers personally know any politician. Although several studies
have examined effects of political connections on firms financing and
performance, Jiangtao Fu et al. (2017) contribute to the previous literature by
distinguishing between large firms and small and medium enterprises (SMEs),
between the loan approval and amount setting processes, and between formal and
informal political connections. They found that politically connected firms are
more likely to be able to borrow from state-owned banks. Moreover, being
connected to the government raises the probability that a firm can receive the
full loan amount it applied for. Several previous studies on the level of
corruption based on firm size show result that the improvement in access to
finance from political connections is more prominent for SMEs than for large
firms. This improvement mostly originates in personal connections with
politicians rather than more formal connections measured by the government
ownership or politicians on the board of directors.

As discussed in several
literatures, political connections are associated with a higher probability
that firms receive credit from banks, and in particular, from state-owned
banks. Most existing studies focus only on the effect of political connections
on whether firms can access bank finance. Some of them, specifically, examine
whether politically connected firms are more likely to be able to borrow as
much as they request, conditional on their having already applied and received
approval for a loan. As a result, they point out a positive effect of political
connections on the amount of loan funds provided to firms. In other word, the
firm’s manager personally connects to the government officials in order to gain
their potential purpose such as receiving the full loan or preferential access
to credit. The more close connection, the more preferential accessing in financial
fund they acquire.

On the other hand, the
drawback of political connection is that the fund is acquired for non-economic
purpose. Managers who raise fund through bribe use fund as means to response
the private benefit of politicians. The misuse of debt financing makes
investments less effective. State-owned banks can lead to misallocation of
resources. The political connection can exacerbate the problem of resource
misallocation from the political view, which assumes that politicians are
self-interested and pursue their own personal, political, and economic
objectives (Sapienza, 2004). If preferential treatment of politically connected
firms involves bribery and corruption, it affects companies that do not have a
strong connection to politics. These companies need loans from banks to invest
in value-added projects for their shareholders. However, the inefficient
allocation of capital has led banks experience management risks and making barrier
to access capital for non-political connection firms. Many studies have proved
this view point in various samples. Particularly, Khwaja and Mian (2005) conducted
a research on firm in Pakistan. The result shows that politically connected
firms in this country borrow 45 percent more and have 50 percent higher default
rates than other firms. This leads to an argument for political connections
distort the risk management of banks. Similarly, Cole (2009) finds that lending
tends to increase in an election year by focusing on government-owned bank
lending in India. This research provides that such lending booms tend to be
costly, as they go hand in hand with a rise in the default rate with no
increase in production for firms.

Using US Department of
Justice data on local political corruption, Jared D. Smith (2015) find the
results that are in contrast to studies in Indonesian market. Particularly, US
firms in more corrupt areas hold less cash and have greater leverage than firms
in less corrupt areas. Further, corruption has the largest association with
leverage among firms that operate primarily around their headquarters. Overall,
Jared D. Smith develops his shielding hypothesis through analysis and giving the
evidence which is consistent with the hypothesis that firms manage liquidity
downward and debt obligations upward to limit expropriation by corrupt local
officials.

Bai, Jayachandran,
Malesky, and Olken (2014) model a setting in which public officials set a bribe
rate and firms pay the bribe or move to another region. Firms view demanded
bribes as a tax they wish to avoid paying. In their model, firms weigh the cost
of the bribe against the cost of moving operations to another region with a
lower bribe rate. Thus, although officials want to extract the maximum bribe,
inter-regional competition keeps bribes from growing too large. However, given
the presumably high cost of moving firm operations, firms could seek an
alternative channel for lowering the bribe rate. Prior studies suggest that
altering financial policies is one channel through which firms could deter rent-seeking.
Matsa (2010) finds that firms strategically use debt in bargaining with labor
unions, suggesting that firms use more debt financing to pre-commit cash flow,
increase profit variability, and increase the risk of bankruptcy. These
empirical findings are tests of theory in Bronars and Deere (1991) and Perotti
and Spier (1993), who argue that firms could use debt to limit concessions made
in a bargaining game by appearing unstable. The notion of sheltering assets
from the demands of labor unions fits naturally within the corruption
literature. In a study on corruption in Uganda, Svensson (2003, p. 219) states:
?The more a firm can pay, the more it must pay. Firms, wishing to maximize
value and limit how much they must pay in bribes, could use financial policies
to reduce liquidity, thereby having less cash to pay bribes. Rent-seeking
officials have incentives to limit expropriation to avoid a firm’s relocation,
bankruptcy, or large reductions in investor returns. Overall, these results are
consistent with firms attempting to shield their resources from rent-seeking.
By reducing liquidity, firms reduce their capacity to pay public officials
(Stulz, 2005), and they make the reduction more credible by increasing leverage
as a way to commit future cash flow in the form of debt service. The empirical
predictions of the shielding hypothesis are that cash is decreasing and
leverage is increasing in the underlying corruption in a firm’s local political
environment. Alternatively, bribing could be optimal for firms if they can buy
political favors. Even supposing that a politically corrupt operating
environment reduces economic efficiency, firms could wish to position
themselves to take bribe opportunities that arise randomly by maintaining financial
policies that make them more liquid, such as a high cash ratio and low
leverage. For example, if a corrupt official were using bribes to auction off a
government contract, a firm that could quickly pay a high bribe could benefit.