2. 3 Economic Challenges Italy Faces in 2016, Stephen Vita | December 30, 2015
http://www.investopedia.com/articles/investing/123015/3-economic-challenges-italy-faces-
2016.asp
The article written by Stephen Vita I in investopedia.com addresses some economic issues Italy
have to face for the year 2016. The Boot is the fourth largest economy in Europe and the eighth
in the world (World Bank). Even so, since the 21st century the country struggle to know growth,
they are far behind European Union. Since the beginning of the Eurozone Italy known a 4%
growth while the GDP of the Eurozone known 10% growth. Besides a low growth the Italian
economy face other problems like high unemployment, 12% in 2015, an important debt, 133% of
the GDP in 2015 and unwell banks with a non-performing corporate loan ratio over 25%. In this
analyse we will see how the Corporate Governance and especially the lack of investor protection
can explain these problems. We will start our analysis by the unwell banks, then we will focus on
the low growth and consequently to the high unemployment and finally we discuss about the
excessive debt.
Before focusing on the problems that Italy face, we have to explain the concept of investor
protection. Investor protection is defined by the extent to which the commercial law and its
enforcement protect investors from expropriation by company insiders (Financial Times). Rafael
La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer and Robert Vishny in Investor protection
and corporate governance, Journal of Financial Economics (1999) show that the investor
protection is a key point for an economy and the lack could bring some problems. Italy is a
country where there is a lack of investor protection. We will use their work (In this analyse we
will call them La Porta, (1999) to make the link between the economics problems mentioned
above and the investor protection.
Italy have a stock market underdeveloped characterized by a lack of investor protection.
According to La Porta (1999), investor protection incites the development of financial markets. In
fact without investor protection, outside investors have no power, no access to information they
need. They also face problems with inside shareholders, which have control of the firm. The main
risk is expropriation. For these reasons, outside investor are not willing to invest in countries with
poor investor protection.
Given that, in Italy financial markets are not well-developed, Italian companies has to finance
themselves with banks. Is that why Italian banks are more exposed to corporate bank loans than
banks in other Europeans countries. The important non-performing corporate loan ratio can be
explained by the fact Italian companies due to poor investor protection don’t attract external
investors and it result difficult for them to manage their finance without these investments.
La Porta says that protecting external investor permit to have more valuable stock markets, larger
numbers of listed securities per capita, higher rate of IPO and larger credit markets. Therefore
investor protection allows financial development. According to a work « Finance and the sources
of growth » made by Beck, T used by La Porta (1999), financial development must accelerate
economic growth by three ways:
- Enhancing savings
- Transformation of savings into real investment
- External investor’s control in investment decisions.
3. This last point must lead the use of financial resources for productive investments and create
economic growth and at least employment.
The low growth maybe explained by the Italian corporate governance system which doesn’t
encourage the investment by external investor so doesn’t encourage the proliferation of financial
markets and economic growth which is correlated with high unemployment.
About the excessive debt, Stephen Vita I say that economists founded a link between low
economic growth and high levels of public debt. Consequently to resolve the public debt
problem, Italy must try to resolve the low growth problem.
With this analyse with have seen that the three economics challenges that Italy have to face in
2016 (sick banks, low growth and high unemployment and excessive debt) could be related with
its corporate governance system. The Italian corporate governance system does not provide
investor protection, which doesn’t appeal external investor to invest in Italian firms. As a result,
Italian firms can’t finance themselves as well they need and put banks in complicated situation.
This also not allow an economic growth which result with high unemployment and excessive
public debt. To face these challenges Italy must reform the corporate governance in his country.
Sources:
Definition of investor protection, Financial Times: http://lexicon.ft.com/term?term=investor-
protection
GDB at Market Price (Current US$), World Bank:
http://data.worldbank.org/indicator/NY.GDP.MKTP.CD
Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, Robert Vishny, 1999. Investor
protection and corporate governance, Journal of Financial Ecnomics 51, 3-27
4. How Much the Best-Performing and Worst-Performing CEOs Got Paid, Joann S. Lublin,
June 25, 2015, http://www.wsj.com/articles/how-much-the-best-and-worst-ceos-got-paid-1435104565
The article How much the Best-Performing and Worst-Performing CEOs Got Paid written by
Joann S. Lublin in The Wall Street Journal deal with the CEO compensation and the company’s
performance. To evaluate the performance he has focused on the return for shareholders. The
result of this study is surprising. From the 10 highest CEO compensation, only one is part of the
best 10% in return for investor. Even more, 2 of them raised their compensation meanwhile the
stock value of the company felt. In general 2/3 of CEO compensation is linked to performance
but for the last third is not the case. Brief examples; Weatherford International PLC offer a 26,1%
negative return to his shareholder and announced to lay off 15% of its workforce. Bernard Duroc-
Danner, Weatherford’s CEO raises his compensation of 13,4%. The case is the same for General
Electric and IBM. The movie The Company Men with Ben Affleck, Kevin Costner and Tommy
Lee Jones show an extreme but good example of weak governance within a company with poor
performance and increasing CEO compensation.
To analyse this case and make a link between this surprising statistic and corporate governance,
we will use Corporate Governance, chief executive officer compensation, and firm performance
done by John E. Core, Robert W. Holthausen and David F. Larcker in Journal of Financial
Economics 51, 1999. We will call this work John E. Core (1999).
To make a link between the CEO compensation and the corporate governance system within the
company we will focus only on bad performers. Indeed the increase in CEO compensation when
they perform well is logic and doesn’t mean that they have a good corporate governance system.
Otherwise when CEOs have a poor performance and raise their compensation it can be explained
by corporate governance structures. The study conducted by John E. Core (1999) showed that
CEO got greater compensation when their corporate governance structures were less effective. To
conduct a solid analyse we will take a look to the board of director of IBM (IBM Board of
directors, 2015), General Electric (GE Board of Directors) and Weatherford (Weatherford Board
of directors).
The first conclusion made by John E. Core (1999) is that CEO compensation is higher when they
also are chairman. For the three companies, the CEO is also the chairman of the board. John E.
Core (1999) also demonstrated that when the board is composed by outside directors, when they
serve on more than three other boards and when they are 70 years old or older member, the CEO
compensation is also higher. The threes boards (IBM, GE and Weatherford) are composed mainly
of outside directors who serve in several boards. IBM and Weatherford also have directors older
than 69. Such composition is sign of bad corporate governance structure. They are optimized for
the CEO and they are ineffective for the firm. The CEO usually hires them, so it’s difficult for
them to take decision adversarial to the CEO who is also the Chairman.
What are the consequences on firm performance? The study made by John E. Core (1999) proves
that the excessive CEO compensation have a negative impact on firm performance. Increase in
excessive compensation is synonym of decrease in return on assets and a decrease in common
stock return. Therefore the consequences are on firm operating performance (decrease in ROA)
and on firm stock market performance (decrease in common stock return).
5. Thanks to the study made by John E. Core (1999) and to the research we made, we can say that
the high CEO compensation and the bad performance of IBM, GE and Weatherford is surely link
to their board of director composition, which demonstrate weaknesses in their corporate
governance structures. In order to improve firm’s performance companies like IBM, GE and
Weatherford have to improve their corporate governance, separating the CEO and the Chairman,
putting more inside directors in the board, imposing retirement ages and limiting the number of
boards on which a director can serve. With such rules improving the corporate governance,
companies should have an effective board of director serving the companies objectives and not
the CEO.
Sources:
IBM Board of directors, 2015. http://www.ibm.com/investor/governance/board-of-directors.html
John E. Core, Robert W. Holthausen, David F. Larcker, 1999. Corporate Governance, chief
executive officer compensation, and firm performance, Journal of Financial Economics 51, 371-
406.
GE Board of Directors. http://www.ge.com/about-us/leadership/board-of-directors
Weatherford Board of directors. http://ir.weatherford.com/corporate-governance/board-of-
directors
6. China Is Gearing Up for Corporate Governance, Therese Niklasson. October 04, 2015
http://www.institutionalinvestor.com/gmtl/3494187/china-is-gearing-up-for-corporate-
governance.html
The article written by Therese Niklasson, China Is Gearing Up for Corporate Governance in
www.institutionalinvestor.com deals with the openness of China to the global financial system.
The Middle Kingdom internationalizes its currency and open its capital markets to foreign
investors. The opening of the second largest economy in the world represents great opportunities
for investors. Nevertheless the country has to face some challenges to attract international
investors in particular in corporate governance. Chinese government is taking several decisions to
improve corporate governance within his country. To analyse the decisions took by Chinese
government we will take a look to the corporate governance problems that traditionally Chinese
companies face and make the link with decisions took by Beijing. For this we will use the work
made by Chong-En Bai, Qiao Liu, Joe Lu, Frank M. Song, and Junxi Zhang, Corporate
Governance and Market Valuation in China, in 2003 in which they analysed governance
mechanisms and their impact in market valuation of Chinese companies.
The principle conclusion of this paper is that there is a real link between corporate governance
mechanisms and market valuation and consequently better-governed companies have higher
market valuations.
According to Chong-En Bai (2003), four main governance problems affect the valuation of
Chinese companies. First, in most time the largest shareholder is too important. For the 1004
companies (represents 95% of listed firms in China at this time) studied, the largest shareholder
own in average 45,3% of total shares. Such ownership structure facilitates the tunnelling (transfer
of resources out of firm for the benefits of the controlling shareholders) like in Enron case. The
second problem is linked the first. 78,7% of the 1004 companies has a parent company. It also
facilitates the resources transfer to the parent company. The next problem is linked with the first
one, 57% of these firms are controlled by Chinese government. According to Scott Cendrowski
(2015), the twelve biggest Chinese firms are state owned and between the 98 Chinese firms
present in the Fortune Global 500, 76 are state owned. The last point is that more than a third of
CEO are also chairman or vice chairman (Chong- En Bai, 2003). As we seen in the previous
article is too often sign of weak governance system.
We also have to add to these governance problems the fact that most companies in China are
audited by Chinese accounting firms and there is no relevant information about the reputation of
these accounting firms.
The study demonstrates that all these governance problems affect the valuation of Chinese firm
and as a result the attractiveness for investor. It also demonstrates that investor in Chinese firm
are interested by high governance standards and are willing to pay premium price. Last but not
least Chinese firms perform better in financial markets when they are open to foreign investment.
Therese Niklasson says that Beijing (the Chinese government) is taking decisions to enforce
regulations and improve corporate governance with the objective to attract investors and in
particular foreign investments.
7. The first decision took by Beijing is a direct response to the problem of state owned companies.
They decided to reduce the government involvement in Chinese firms selling equity to private
and institutional investment funds. This decision should change the board structure increasing the
number of independent directors.
The second decision deals with the auditing practices. Chinese government will open the audit of
state owned enterprises to independent accounting companies. This decision will help both local
and foreign investors providing them transparency and access to right information. Finally
Shanghai Stock Exchange promotes governance training and electronic voting. Electronic voting
is very useful for investor to exercise their rights easily.
The openness of Chinese companies to the global financial system and foreign investment result
in improvement on governance standards. Indeed the Chinese government is working to provide
significant changes in his country in order to respond to the governance problems highlighted by
Chong-En Bai, (2003). However, even if the opening of the Middle Kingdom is a great
opportunity for foreign investors and that some changes are improving governance, China still
have to work hard to provide good governance standards.
Sources:
Chong-En Bai, Qiao Liu, Joe Lu, Frank M. Song, and Junxi Zhang, 2003. Corporate Governance
and Market Valuation in China, William Davidson Working Paper Number 564.
Scott Cendrowski, 2015. China's Global 500 companies are bigger than ever—and mostly state-
owned. http://fortune.com/2015/07/22/china-global-500-government-owned
