High-level politically connected firms, corruption, and analyst forecast accuracy around the world
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High-level politically connected firms,
corruption, and analyst forecast accuracy
around the world
Charles JP Chen1,Yuan Ding1 andChansog (Francis) Kim2
1China Europe International Business School,
Shanghai, P. R. China; 2City University of Hong
Kong, Hong Kong, P. R. China
Correspondence:CJP Chen, China Europe InternationalBusiness School (CEIBS), 699 HongfengRoad, Pudong, Shanghai 201206, P. R.China.Tel: 86 21 2890 5617;Fax: 86 21 2890 5620;E-mail: email@example.com
Received: 15 July 2008Revised: 8 January 2010Accepted: 12 February 2010Online publication date: 24 June 2010
AbstractThe international business (IB) literature has widely recognized political forces
as major factors that complicate the strategic decisions of multinationalenterprises (MNEs). Analyses by financial intermediaries can help to reduce the
risk of information asymmetry caused by such factors. Using firm-level data
from 17 jurisdictions between 1997 and 2001, this study investigates theassociation between a firms high-level political connections and earnings
forecasts made by financial analysts, an important group of financial
intermediaries. We find that, after controlling for other determinants offorecast accuracy, analysts experience greater difficulty in predicting the
earnings of firms with political connections than those of firms with no such
connections. However, in jurisdictions in which corruption level is relativelyhigh, earnings forecast accuracy is influenced more by a firms political
connections. Our findings contribute to the IB literature by demonstrating that
political connections exacerbate the information asymmetry between investors
and managers, and also that anti-corruption measures can curb the adverseeffect of political connections on the corporate information environment.
These findings bear the practical implication that MNEs must consider political
issues when making resource allocation decisions.Journal of International Business Studies (2010) 41, 15051524.doi:10.1057/jibs.2010.27
Keywords: political relationships; corruption; primary data source; accounting
INTRODUCTIONCorporate political connections play an important role in many ofthe worlds largest and most important economies (Fisman, 2001).Anecdotal evidence suggests that political connections substan-tially affect corporate performance not only in emerging markets,but also in developed economies. For example, in 2002 Shin Satellite(Sattel), a Thai telecom company, 53% owned by the family of thethen Thai prime minister Thaksin, obtained government assistanceto expand utilization of its massive capacity: The Indian govern-ment renewed its contracts with Sattel after Thaksins whirlwindtrip; Sattel made a $12 million deal with Burma right after anofficial visit to Thailand by a Burmese leader (Crispin, 2002).Political connections also played a role in the Enron scandal. WhenPresident Bushs advisers debated a new energy policy in the springof 2001, Kenneth Lay (President of Enron) was the only energyexecutive to be invited for a one-on-one session with Vice President
Journal of International Business Studies (2010) 41, 15051524& 2010 Academy of International Business All rights reserved 0047-2506
Cheney, who led the effort. Mr. Lay also workedwith Karl Rove and others to successfully push fortheir appointments to the Federal Energy Regula-tory Commission (FERC), which oversaw muchof Enrons business. According to Curtis Hebert Jr.,ex-chairman of the FERC, President Bush replacedhim with an old Enron ally from Texas soon after herefused to change his views on electricity deregula-tion to concur with those of Mr. Lay (Davis, 2001;Hunt, 2002).
The international business (IB) literature hasshown that political connections not only affectfirm-level performance and transparency, but alsowork hand in hand with corruption, which pro-duces bottle necks, heightens uncertainty, andraises costs for cross-border business transactions(Habib & Zurawicki, 2002). Further, the IB literaturehas established the effects of political forces onthe strategic choices of multinational enterprises(MNEs) (Smith-Hillman & Omar, 2005), and hasshown that politics in general and corporatepolitical connections specifically systematicallyinfluence business practices around the world(Faccio, Masulis, & McConnell, 2006; Habib &Zurawicki, 2002; Simon, 1984).
Though corporate political connections are a wide-spread phenomenon around the world (Faccio,2006), and the IB literature has recognized thecomplex relationship between MNEs and society,research on the interactions between MNEs andpolitics, corruption, and corporate social responsi-bility is still relatively embryonic (Rodriguez, Siegel,Hillman, & Eden, 2006). We explore this relativelynew research area in the IB literature by providingevidence about the effects of:
(1) high-level corporate political connections;1
(2) host-country corruption levels; and(3) their interaction on the ability of financial
analysts to forecast the earnings of corporationsaround the world.
Scholars know that institutions matter, butdo not know exactly how they matter to MNEs(Jackson & Deeg, 2008). Understanding the rela-tionship between political connections and analystforecasts brings us a step closer to this end, as itsheds light on the dynamic relationship betweenhost-country politics and MNEs. Hence this is notonly a less traveled path but also a relativelypromising research direction.
The accuracy of earnings forecasts reflects thelevel of information asymmetry between (sophisti-cated) investors and managers (Duru & Reeb, 2002;
Krishnaswami & Subramaniam, 1999), which is animportant issue for both MNEs and IB scholars(Jackson & Deeg, 2008). Researchers have identi-fied both firm-level and institutional factors thataffect analyst forecasts (Brown, 1993; Clarke &Subramanian, 2006). We propose that in additionto the inherent uncertainty of earnings, politicalconnections complicate the analysts task, becausepolitical favoritism is usually granted covertly, andoften comes in a windfall fashion that distortsthe time-series pattern of reported earnings. Thisconjecture, which we refer to as the analyst taskdifficulty hypothesis, predicts that analyst earningsforecasts should be less accurate for firms withpolitical connections than for firms without suchconnections. Alternatively, one may contend thatpoliticians can use their influence to help con-nected firms smooth their earnings by transferringpolitical favors when earnings are low, thus makingtheir earnings more predictable. This supposition,which we refer to as the income-smoothing hypoth-esis, predicts that analyst earnings forecasts shouldbe more accurate for firms with political connec-tions than for firms without such connections.2 Wefind that corporate political connections adverselyaffect financial analyst forecast accuracy, whichimplies that the effects from analyst task difficultydominate those from income-smoothing.
We also propose that corruption can exacerbatethe impact of political connections on analystforecasts by aiding politicians in transferring ben-efits to connected firms (Faccio, 2009), obscuringthe disclosures of politically connected firmsabout the impact of their connections on financialperformance, and subjecting analysts to unduepressure from connected firms and politicians. Thisconjecture, which we refer to as the corruptioneffect hypothesis, predicts that the effect of politicalconnections on analyst forecast error is morepronounced in jurisdictions with higher levels ofcorruption. Our empirical results support thishypothesis.
It is important to consider the two-way interac-tion between a host countrys political system andMNE strategies, as corruption is more widespreadin countries with opaque legal systems and exces-sive administrative discretion (Boddewyn, 1988;LaPalombara, 1994; Tanzi, 1998), and politicsaffects an MNEs strategic choices (Smith-Hillman& Omar, 2005). Analyzing political connections inisolation from the host countrys corruption levelmay limit the ability of IB scholars to understandthe complex nature of the relationship between
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corporate political connections and analyst fore-casts. Our focus on the interaction between poli-tical connections and the effect of corruptionexplicitly considers the possibility of a two-wayinteraction between these two factors, as the extentof corporate political connections may alter ahost countrys incentives and/or ability to controlcorruption, and the effectiveness of a governmentsanti-corruption measures may in turn affect theincentives for corporations to seek political bene-fits. Our results suggest that political connectionsmask financial transparency around the world, andthat the level of host-country corruption affects thediscretion that politicians have in granting politicalfavors.
The remainder of this paper proceeds as follows.The next section develops the hypotheses. Thethird section presents the variable measurementsand empirical models. The fourth section identifiesthe data sources, and reports the descriptivestatistics. The fifth section discusses the results ofthe empirical analyses. The sixth section sum-marizes the results of the robustness checks. Thefinal section presents our conclusion.
HYPOTHESIS DEVELOPMENTThere are four primary tools with which the statecan influence the economic performance of a firm(Stigler, 1971): direct capital subsidies, controlover the entry of new rivals, the regulation ofsubstitutes and complements, and price fixing.Each of these tools can be expected to complicatethe earnings forecast task. However, political forcescan also affect MNEs in a broader way. In additionto home-country political risks, MNEs may alsobe exposed to differential tax policies, indigeniza-tion or even nationalization, technology transferrequirements, equity ownership restrictions, andindustry entry barriers.3 Financial analysts possessexpertise in forecasting the financial prospectsof a firm primarily because of their understan-ding of the market in which the firm operates.However, analysts are less equipped to predictthe outcomes of political decisions, and much lesstheir expected effect on the future cash flow of afirm.4
We argue that political connections add a dimen-sion to the task of forecasting corporate earnings.This aspect of complexity is not reflected in thehistorical information derived from a firms earn-ings attributes, such as the time-series patterns ofearnings or the characteristics of past accountingaccruals, mainly because the effects of political
connections are not normally recurring, nor arethey cyclical. The ability of politicians to influencecorporate performance is much less predictablethan normal business cycles, as changes in thepolitical landscape are not affected only by formalinstitutional arrangements, such as elections orappointments. Many random factors can easily andunexpectedly overwhelm the political equilibrium,including the physical health of connected politi-cians. For example, Fisman (2001) finds that theshare prices of companies connected to IndonesiasPresident Suharto dropped upon news of hisdeclining health, which indicates that, althoughseemingly non-financial in nature, the news of apoliticians personal well-being can substantiallyaffect the financial performance of the firms withwhich that politician is connected.
In addition, the impact of political connectionsinteracts with business cycles to obscure the latterseffect on the reported accounting profits of con-nected firms. In times of business downturn inparticular, politicians may extend assistance toprop up the reported earnings of connected firms.For example, in 2003, Silvio Berlusconi, the Italianprime minister and owner of AC Milan footballclub, passed the football savior law that permitsclubs to amortize the massive costs of playercontracts over 10 years rather than the shorterlifespan of the contracts (Kapner, 2003: 26). At atime when most clubs in Italy were faced withfinancial problems without increasing sales reven-ue, the ratification of this law interrupted the time-series patterns of earnings for AC Milan by halvingits reported loss for the third quarter of 2003 to$33.8 million, which substantially altered thefinancial reporting outcome and created unex-pected complications for financial analysts.
Political Connections and Forecast AccuracyDuru and Reeb (2002) argue that earnings forecasterror depends on the difficulty or complexity of theforecasting task, and show that analyst earningsforecasts are less accurate for MNEs than fordomestic firms. We propose five non-mutuallyexclusive explanations for why political connec-tions increase information asymmetry betweenanalysts and managers and hence make analystforecasting more difficult.
First, political connections add a new dimensionto the earnings generation process. Krueger (1974)suggests that entrepreneurs expend resources onpoliticians to compete for the economic rentsthat may be granted by the government. The
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payback from political connections often comesunexpectedly, which inevitably disrupts the time-series pattern of the reported earnings of connectedfirms, thus making the analyst forecasting taskmore complex.5 These possible impacts on earningsmay be either direct (favorable tax treatment,profitable projects, preferential access to markets,cheap financing, and government subsidies)6 orindirect (injections of cash or non-cash assets thatincrease the future profitability of the connectedfirm). Either way, the increased uncertainty com-plicates the forecasting task of analysts. Further-more, there is additional uncertainty about whenand how much government aid the connected firmmight receive. Although political forces tend toremain stable between scheduled changes in thepolitical landscape, uncertain election outcomesand the eruption of scandals often swing the powerpendulum unexpectedly, leading to erratic award-ing or disruption of political favors that adverselyaffects the accuracy of analyst forecasts.
Second, political connections are often linked togreater opacity at the firm level (Bhattacharya,Daouk, & Welker, 2003). Government-providedshielding from market monitoring mechanisms(e.g., regulatory disclosure requirements and inves-tor demands for transparency) may allow managersof politically connected firms to enjoy morediscretion over financial disclosure. This increasesthe information asymmetry between analysts andmanagers, which in turn makes the analyst fore-casting task more difficult.
Third, variation in investor demand for informa-tion can affect the properties of analyst forecasts(Barth, Kasznik, & McNichols, 2001). Politicallyconnected firms have less need to raise capital fr...