Aurora Borealis
1 February 2017 CFA Institute Journal Review

Impact of Domestic Investor Protection on Foreign Investment Decisions: Evidence from Bond Markets (Digest Summary)

  1. Rich Wiggins, CFA

The difference between domestic and foreign creditor protections matters for investment decisions. The impact on cross-border investment in bonds is twofold. If domestic creditor protection is more efficient (less efficient) than foreign creditor protection, the sensitivity of foreign investment to creditor protection decreases (increases). Domestic creditor protection for foreign investment is more robust than creditor protection in destination countries, so investors with a high level of investor protection at home are less sensitive to investor protection in foreign countries.

What’s Inside?

What drives international equity and bond holdings? Under the assumption of perfectly efficient capital markets, all investors should hold the same market-capitalization-weighted portfolio, whereby the allocation of each investment corresponds to its weight in the world market portfolio. If diversification costs exceed diversification benefits, home bias arises. Law influences shareholder protection, agency cost control, and investor behavior, but existing studies on foreign securities bias explore the importance of investor protection for equity investments. The focus of this study is how domestic creditor protection affects foreign investment decisions in debt markets.

How Is This Research Useful to Practitioners?

A significant amount of previous work on investor protection investigates the effects on financial market development—that is, the supply of securities, leaving the demand side less explored. The author contributes to the existing literature on home bias by exploring the demand relationship between domestic creditor protection and foreign investment decisions in bond markets. It is unclear whether the results of previous equity studies can be extended and expected to hold equally between equity and fixed-income markets: Countries characterized by strong protection of shareholder rights are less attractive to bondholders because they represent competing claims. The impact is probably asymmetric because information is less relevant for bonds, which represent the payoff of a fixed claim, than equities, which are the payoff of a residual claim.
Shareholders implicitly compare foreign and domestic creditor protections when determining portfolio allocations to foreign securities, but several concepts have evolved that relate shareholder protection to foreign investment. The “good country bias” theory implies that portfolio investors in countries with weak shareholder protection invest more in foreign stocks than do portfolio investors in countries with stronger protection of their rights. It is likewise intuitive that investors in countries where their rights are well protected are less likely to diversify their portfolios abroad. The “comparative corporate governance” theory is based on the assumption that the driver of foreign investment decisions is based on the relative strength of foreign investor protection compared with domestic investor protection. This study is an extension of both the “good corporate governance” theory, which focuses on absolutes, and the “comparative corporate governance” theory, which focuses on relatives. It shows that the impact of domestic creditor protection on cross-border investment is twofold and involves an interaction effect. Foreign portfolio composition is indirectly affected by domestic corporate governance.

How Did the Author Conduct This Research?

Over the last several decades, corporate governance literature has highlighted the importance of the institutional environment in which investing takes place. The environment for investor protection is generally viewed in terms of such national-level factors as the legal framework for property rights and the credibility of a country’s judicial system in enforcing laws against white-collar crime, malfeasance, corruption, and expropriation. The institutional literature has been advanced through comparative studies that examine the relative underweighting or overweighting of assets to a theoretical optimal benchmark. Such studies often split the universe of investors into inside and outside investors to test whether corporate governance evenly affects all portfolio investors or instead is particularly relevant to foreign investors.
The author follows existing literature by analyzing the annual cross-border investment of 22 major developed and 15 developing countries over 2004–2012. She computes measures of foreign bias by using data from the Bank for International Settlements (BIS) and the International Monetary Fund (IMF)—the most comprehensive and widely used datasets, though not perfect. Indexes of creditor rights attempt to distinguish between the existence and the enforcement of creditor protection laws. Creditor rights are complicated by the fact that heterogeneity exists within bondholders as a group. Senior creditors may prefer liquidation, which guarantees repayment of their claims, whereas junior bondholders may favor “going concern” solutions. Creditor protection is further complicated by distinctions between sovereign debt markets and corporate debt markets. The author uses the ordinary least-squares method as the main estimation technique to measure and account for time effects across both pre-crisis and crisis periods.

Abstractor’s Viewpoint

In these globalizing times, a leading question in corporate law is whether there exists a national corporate governance system with a comparative advantage or whether national corporate governance systems will converge to a new hybrid of the best practices drawn from different systems. Comparative governance, however, is subjective and has a reactive quality. In the 1990s, US observers looked to Japan’s governance practices for guidance, but US competitiveness rebounded; today, ironically, there is talk of US-style reform in Japan. It is difficult for studies of comparative data to establish causal connections. In addition, the author does not address how culture and patriotism affect portfolio allocation decisions.

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