Research Digest When political connections actually harm firm value: lessons from a case study
In “Sleeping with the enemy: The perils of having the government on (the) board”, published in the Journal of Comparative Economics, Professor Santiago Barraza, along with co-authors Martín A. Rossi and Christian A. Ruzzier, exploit the unique natural experiment represented by the 2008 nationalisation of Argentina's pension system to study the impact of unsought political connections on firm market value.
Why study this
Corporate ties to governments and politicians, often called political connections, are widespread throughout the world, and while the academic literature has provided ample evidence of a positive relationship between political connections and firm value, the authors argue those previous estimations could be potentially biased. If firms actively seek to establish those connections that create value and avoid those that can destroy it, then the observed connections likely overrepresent the positive cases, while underrepresenting the negative ones. This introduces a sample selection problem, which can bias estimations. To address this concern and obtain unbiased estimates of the effect of political connections on firm value, the authors exploit a natural experiment that delivers quasi-random assignment of new political connections to firms. This experiment is the 2008 nationalization of the Argentine pension system, which transferred to the government the equity shares of dozens of publicly-traded firms, allowing it in some cases to also appoint board directors.
- The main finding of this study is that quasi-randomly assigned political connections can actually decrease firm market value if the government not only becomes a shareholder, but also obtains the right to appoint directors to the board, which arguably allows it to effectively intervene in the firm decision process.
- On average, a firm in which the government can appoint at least one director suffers a market value loss of between 23 and 40 percent, when compared to a firm in which the government neither becomes a shareholder nor obtains the right to appoint directors. This is in stark contrast with previous findings documented in the literature.
- The loss in firm value cannot be explained by reduced stock liquidity or increased return volatility, making decreased expected cash flows to shareholders a likely explanation.
Political connections appear to be detrimental to firm value as perceived by the market, but only when these connections materialise in the form of government directors appointed to the board of the firm.
These results for Argentina apply to many other countries with weak institutional environments or high corruption; they are important, in light of the increasing presence of politicians on corporate boards all over the world, especially in the wake of the Great Recession.
“Political connections are detrimental only when they grant the government a concrete ability to interfere with firm activities (e.g., to drive firms towards political rather than economic goals, or to engage in rent seeking).”