The relationship between liquidity, corporate governance, and firm valuation: Evidence from Russia
Highlights
► We examine the hypotheses that liquidity improves corporate governance, and better governance enhances valuation of Russian firms. ► Positive causal relationship between measures of liquidity and corporate governance. ► Strong positive impact of corporate governance on valuation. ► 10% decrease in liquidity measure implies a 0.34% increase in corporate governance, which in turn leads to a 9.6% increase in firm valuation.
Introduction
This paper examines the channel relationship between stock market liquidity, corporate governance, and firm valuation of Russian firms from 2002 to 2009. The impact of liquidity on corporate governance is still a subject of debate in academic literature. One strand of literature argues that market liquidity has a negative impact on efficiently governed firms as excess monitoring by small investors can undermine the control of large active institutional investors.3 On the other hand, Maug (1998) argues that liquid equity markets allow large investors to profit from monitoring through informed trading and helps to alleviate the free-rider problem. The active debate over the role of liquidity as a mechanism to improve corporate governance is one of the motivating factors for the current research. Furthermore, most empirical studies on the relationship between market liquidity and corporate governance focus on developed markets, which are often dissimilar to emerging markets. The current research is also related to the literature that investigates the impact of corporate governance on firm value.4 The majority of evidence from this literature finds that firms with better corporate governance ratings or stronger shareholder rights have higher valuations. Motivated by these two lines of research, we study the causal relationship between liquidity, corporate governance, and firm valuation of Russian firms.
This paper focuses on Russian firms partly due to the accelerating growth of Russia in global financial markets. Fig. 1 displays the evolution of the Russian Trade System (RTS) index over the period of 2002–2009. During the period from 2002 to 2007, the RTS index increased 539%. The RTS shows a sharp decline at the onset of the global financial crisis, but even accounting for this, the RTS added 302% over the sample period. Moreover, according to a global survey conducted in 2008 by Ernst & Young, the capital raised by Russian initial public offerings in 2007 ranked the fourth, behind only China, the U.S., and Brazil. With vast natural resources still underutilized, one would anticipate the ability of Russian firms to obtain external capital to increase in the years and decades to come. The Russian business environment is characterized by weak legal frameworks, high ownership concentration, significant state involvement in management, and underdeveloped equity markets.5 The nature of the Russian business environment makes the gains from small improvements in corporate governance significantly high. An example of the impact of corporate governance on valuation comes from Russia's largest company, Gazprom. Lazareva et al. (2007) report that Gazprom's valuation reflects only $1 per barrel of proven reserves, while western oil companies, such as Exxon Mobil or Royal-Dutch Shell, are valued at approximately $18 per barrel of proven reserves. As Fig. 1 illustrates, Russia has seen improvement in its corporate governance over recent history, but still lags behind many western countries.6 As more investors seek to capitalize on the growth of the Russian equity market, the importance of corporate governance will become paramount.
Few empirical studies examine the relationship between liquidity, corporate governance, and firm valuation. Although Fang et al. (2009) find a positive relationship between liquidity and firm value for U.S. firms; they do not model the impact liquidity on governance variables. In a paper most related to the current study, Lang et al. (2012) investigate the relationship between firm-level transparency, stock market liquidity, and valuation across 46 countries over the period of 1994–2007 using a fixed effect model. They document the positive significant impact of transparency on liquidity and firm valuation. The current study is distinct from Lang et al. in that they do not include Russian firms in their sample and their model does not allow them to explore the causal relationships between governance, liquidity, and firm valuation.
In a paper on Russia, Black et al. (2006) address the impact of corporate governance on firm valuation. They document a strong positive relationship between corporate governance and firm valuation for Russian firms from 1999 to 2005. We build on the work of Black et al. (2006) by directly incorporating liquidity into the empirical framework, which was absent from their study. The present research incorporates all three variables and aims to provide empirical evidence of the channel relationship between liquidity, corporate governance, and firm valuation in Russia.
To examine the causal relationship between liquidity, corporate governance, and firm value, we study a broad cross section of Russian firms over the period of 2002 to 2009. Liquidity has multiple dimensions. To capture these various aspects, three liquidity measures are used following existing literature on liquidity.7 The data are paired with the transparency and disclosure (TD) scores provided by Standard and Poor's which are used to proxy corporate governance. Finally, control variables and Tobin's Q are added to our system of equations to address the following two major research questions: 1) Does liquidity improve corporate governance in Russia? 2) Does better corporate governance lead to higher firm valuation?
The results of our empirical investigation are broadly consistent with the theoretical work of Maug (1998) that liquidity improves corporate governance and the empirical work of Black et al. (2006) that better corporate governance enhances firm value in Russia. We find a positive causal relationship between measures of liquidity and corporate governance. This finding is robust to all three measures of liquidity commonly used in literature. Additionally, this paper documents the strong positive impact of corporate governance on enhancing Russian firm valuation. Our results are not only statistically significant, but also economically significant. For example, we document that a 10% decrease in the proportion of zero return days implies a 0.34% increase in transparency and disclosure, which in turn leads to a 9.6% increase in firm valuation as measured by Tobin's Q. When liquidity is measured as volume, we find similar strongly economically significant results. Where a 10% increase in the dollar trading volume of a firm leads to a slight improvement in corporate governance, but that slight improvement leads to a 2.9% increase in market valuation relative to book value. The findings of our study highlight the importance of market liquidity on corporate governance and valuation for Russian firms.
The remainder of the paper is organized as follows: Section 2 reviews related literature, Section 3 describes the data and the methodologies, Section 4 discusses the empirical results, and Section 5 provides a summary of observations and directions for further research.
Section snippets
Literature review
We review related literature along three categories: 1) liquidity and corporate governance, 2) liquidity and firm value, and 3) corporate governance and firm valuation.
Hypotheses and methodologies
To understand the simultaneous linkages between liquidity, governance, and firm value, we develop our null hypotheses based on the theoretical work of Durnev and Kim (2005), and Maug (1998). Maug (1998) argues that large shareholders have the incentive to monitor a firm because a liquid market allows them to acquire a large stake of the firm with lower cost. This increased monitoring improves internal corporate governance mechanisms. Durnev and Kim's theoretical model predicts that better
Correlation of key variables
Prior to estimating our simultaneous system of equations, we report in Table 2 the correlation of major variables. We note several interesting features in the relationship between major variables of interest. First, looking at variables that are correlated to our measure of transparency and disclosure (TD), we find several noteworthy correlations. Sales and total assets tend to be positively correlated to TD, indicating that larger firms are more transparent. This could also be due to the fact
Conclusions and future research
Since a group of economists at Goldman Sachs developed the acronym BRIC, to highlight the potential growth of the Brazilian, Russian, Indian, and Chinese economies, tremendous attention has been paid to these emerging markets. This paper focuses on the role of liquidity on corporate governance and firm valuation of Russian firms. The Russian business environment is characterized by weak legal frameworks, high ownership concentration, significant state involvement, and underdeveloped equity
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