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Network Governance & Firm Performance in Malaysia Monica Guo-Sze Tan Department of Management, Monash University. Prof. On-Kit Tam Department of Management, Monash University. Contact Details: Business and Economics Postgraduate Research Centre Unipath Building, 840 Dandenong Road, Caulfield, VIC 3145, Australia. Phone: (61) (3) 9903 1530 Fax: (61) (3) 9903 2718 E-mail: monica.tan@buseco.monash.edu.au 1 Network Governance & Firm Performance in Malaysia ABSTRACT Research has shown that business and political networks play significant roles in emerging markets. This paper examines how different ownership types utilise networking, political network and affiliation with financial institution, to maximise their interests and the impact on firm performance among the largest listed firms in Malaysia. Discussion on the formation of networking is examined in the light of the mandatory distribution of corporate ownership under the forces of the national socio-economic policy. Implications from results are drawn to show how the impact of networking influences the formation of governance system. Empirical results show that Bumiputera Individual owned firms have the highest association with political networking while Non-Individual owned firms have the most affiliation with financial institution. Both networking types have negative impact on firm performance but are positive towards growth in firm size. Networking in Malaysia is argued to increase expropriation risks and deter market competitiveness. INTRODUCTION This paper aims to explore how ownership types affect networking and the impact of this relationship on firm performance in Malaysian listed firms. Two measures of networking are examined: political link (POLITICS) and affiliation with financial institution (FINANCIAL). The rationale of this study is to explore the justification behind each ownership type in its differing preferences of networking and how firm performance is affected; in turn, drawing implications on how this affects corporate governance. The distribution of capital ownership in Malaysia is an interesting issue. In the early period after independence, classification of occupations according to ethnic groups is prominent, resulting in wide discrepancies in household incomes among ethnic groups (Malaysia, 1971). The government has initiated to solve the problem by actively allocating capital ownership in the corporate sector according to pre-determined quota for each ethnic group. Consequently, the New Economic Policy (NEP) was enacted in 1971 while governmental intervention in the national economy continues to grow. The Malaysian corporate sector also shares many of the emerging market features, such as low enforcement in investor protection, underdeveloped financial market and close-knit business networking. 2 Empirical evidence shows that there are differences in the adoption of different types of networking according to ownership types. Bumiputera-Individual owned firms have the highest incidence of political links while Non-Individual owned firms have the closest link to financial institution. Networking is found to have negative impact on firm performance for most firms but is a contributing factor to firm’s size growth in market capitalisation. The first section describes the Malaysian corporate sector, which is followed by the arguments built to explore the relationships between ownership types and each of the networking types, POLITICS and FINANCIAL. Section three discusses the methodology used in this study and results follow. Implications will be discussed in section six and conclusion is drawn in the final section. MALAYSIAN CORPORATE SECTOR In Malaysia, NEP 1971 together with the enactment of the ICA Act 1975, requires all enterprises, with equity over a specific limit, to sell 30 percent of their shares to Bumiputera (Perkins and Woo, 1998). The policy was recognised by some researchers as an “ethnicity- oriented policy” (Torii, 1997) because it specifically laid out the plan to attain 30 per cent in terms of corporate ownership and management for Bumiputera by 1990 (Malaysia, 1971). As a result, massive governmental intervention in the corporate sector has begun. Besides heavily influencing the distribution of corporate wealth, the NEP has serious implications on other aspects of the Malaysian national economy. Torii (1997, p. 210) argues that the policy “partially restricts the full play of economic rationality as well as the market mechanism and equal opportunity principles in favour of Malay-first ethnicity principles coupled with political favouritism”. La Porta, Lopez-de-Silanes, Shleifer and Vishny (1998) have found that Malaysia’s relatively good protection of shareholders, originated from the legal family of common law, is lacking effective enforcement. The heavy governmental intervention might have impaired the enforcement of law and order in the corporate sector 3 because ownership is distributed to rather than achieved competitively by investors. Consequently, Bumiputera investors’ rights are shielded under the umbrella of NEP 1971 while Non-Bumiputera are left to strive for their own survival in any possible way, which include concentrating shareholding in their firms. The differences in law and the quality of enforcement are very much closely related to methods of financing corporations (La Porta, Lopez-de-Silanes, Shleifer and Vishny, 2000). In other words, investors are willing to finance corporations when the overall legal frameworks offer substantial protection for them; in an environment with low protection of investors, corporations would be forced to rely heavily on internal and other means of financing, such as debt (La Porta et al., 2000). The financial and banking institutions in the country mainly make up the capital markets in Malaysia. In the absence of a mature equity markets, equity investors’ rights and protections are underdeveloped. Equity financing is then limited to internal generated cash flows in firms and the capability of the few wealthy large investors investing as substantial shareholders in many corporations in the country. In such a unique environment, where governmental intervention is strong, investors’ protection is not enforced effectively and financial market is immature, this study could provide new insights into how investors of different types adopt networking as their competitive advantage and essential mutual governance tool. Under the uneven socio- economic policy, this study will explore how Bumiputera-Individual (BUMIPUTERA), Non- Bumiputera-Individual (NON-BUMIPUTERA), Sino-Malay Individual (SINO) and Non- Individual (NI) shareholders differ in their use of various means of networking and how this affects firm performance. NETWORKING IN MALAYSIA Networking replicates the structure of market when imperfect developments are in place, especially in developing nations. The rationale behind cultivating networking has been 4 enormously researched in which networking is argued to provide financing, mutual governance, business opportunities and resource sharing among parties involved (Hamilton, 1996; Redding, 1996). This paper focuses on two types of networking: POLITICS and FINANCIAL. The following section will elaborate on the development of arguments for each of the types. Political Network Listed firms which are said to have POLITICS are those that have established ties with certain political party or politician. As trust being an important element in many Asian cultures, sharing of information is often conducted at minimal level with non-associated parties (Redding, 1996). POLITICS offers competitive advantage to entrepreneurs and firms (Yoffie and Bergenstein, 1985). Network becomes a hub in which business leaders could access information, explore business opportunities and threats. This could reduce transaction costs as implicit contracting could be made quickly and bureaucratic red-tapes are cut tremendously. Also, networking could assist corporate governance as rapid exchange of information helps entrepreneurs to keep track of their business dealings and performance. Furthermore, through networking, scrutiny and retribution could be reached by denying one business facilities and opportunities. POLITICS could also pressure for favourable policies to be enacted (Yoffie and Bergenstein, 1985). In a political relationship, exchange is made between firms and governments or political players in which the former obtains advantage in propitious policy and facilities, in return, they help the latter in providing for the public (Hadjikhani and Ghauri, 2001). Investors of various ethnicities utilise POLITICS to achieve different objectives in Malaysia, as a result of segregation of economic activities among ethnicities and the impact of NEP 1971. Traditionally, Bumiputera engage themselves in peasantry while Non- Bumiputera, especially Chinese, are actively involved in trades (White, 1997). However, in 5 the post-independence period, it could be argued that Bumiputera entrepreneurs adopt influential1 measure while their Non-Bumiputera counterparts take on adaptive2 measure in cultivating their POLITICS based on Hadjikhani and Ghauri’s (2001) study of international firms’ behaviour in cultivating political ties. NON-BUMIPUTERA could protect and enhanced their interests in the corporate sector by joining ventures with BUMIPUTERA, as steps to access resources and funds which they could not otherwise approach, and to maintain good relationship with the state by appointing BUMIPUTERA who have close POLITICS to the board of directors of their firms (Gomez and Jomo, 1997). However, as the government and political environment have been dominated by BUMIPUTERA in Malaysia, cultivating POLITICS are difficult for NON- BUMIPUTERA. Furthermore, with the emphasis on correcting racial economic imbalance and raising BUMIPUTERA ownership stake in the corporate sector, the priority for NON- BUMIPUTERA is placed lower than their BUMIPUTERA counterparts in the national economic development. Therefore, NON-BUMIPUTERA entrepreneurs could only adopt adaptation measures in POLITICS for the survival and growth of their businesses. As latecomers, BUMIPUTERA, who have less knowledge and experience in the corporate sector, could access resources, fund and opportunities to build new wealth through POLITICS (Gomez and Jomo, 1997). It is also argued that politicians or political parties, such as UMNO, invest in corporate sector by using BUMIPUTERA leaders as proxy investors (Gomez and Jomo, 1997). With their close relationship with politicians, BUMIPUTERA could influence policy making and make business opportunities more accessible for their firms. At the same time, they assist the government in fulfilling the 1 Influence is the measure in which an actor alters the political rules in favour of the companies involved. Hadjikhani, A. and Ghauri, P. N. (2001) "The behaviour of international firms in socio-political environments in the European Union", Journal of Business Research, Vol. 52, No. 3, pp. 263-275. 2 Adaptation is the measure in which an actor recognizes and abides by the political rules that have been in place. Ibid.Vol., No. 6 objectives of socio-economic policy and raising the status of BUMIPUTERA in the corporate sector. Johnson and Mitton (2003, p. 353) argued that relationships between entrepreneurs and politicians in Malaysia are based on “chance personal histories” and is found to have negative impact on firm performance during the Asian Financial Crisis 1997. In these firms, agency problem become more severe as the risk of shirking increases with the involvement of political agents in the firms’ external environment, which might eventually lead to cronyism and bribery. However, as the rationale of cultivating POLITICS differ among ownership types, the level of performance might also varies accordingly. Therefore, this study examines the impact of POLITICS on firm performance by further separating the firms according to their ownership types. Besides firm performance, POLITICS are argued to bring growth and expansion to firms, especially BUMIPUTERA owned, because of favourable deals and access to opportunities (Gomez and Jomo, 1997). Hypothesis 1: Use of POLITICS varies according to ownership types. Hypothesis 1a: BUMIPUTERA firms have the highest incidence of POLITICS. Hypothesis 2: The impact of POLITICS on firm performance varies according to ownership types. Hypothesis 3: The impact of POLITICS on firm size varies according to ownership types. Financial Institution Affiliation FINANCIAL refers to having affiliation with at least one financial institution in the same corporate group. The examination on FINANCIAL is a crucial issue in environments with immature financial market because the strength of financial ability not only determines the survival and growth of businesses, but also affects corporate governance in the corporate sector. In family businesses, initial endowments of resources and capitals are drawn from the families’ funds and their close relatives and friends (McConaughy, Matthews and Fialko, 2001). This is in place because of the underdeveloped financial market which does not offer 7 many options except for debt financing. On the other hand, NI firms are not as restricted in their financial resources, for example, foreign firms could draw funds from international market; state-owned and trust fund firms could utilise large pool of domestic funds (Tan, 2003). Therefore, it is not surprising that NI firms could be argued to have stronger FINANCIAL. NON-BUMIPUTERA have a long history in the corporate sector of Malaysia. Many of the successful businesses are founded by entrepreneurs with substantial experience and accumulated wealth over the years. On the other hand, BUMIPUTERA build their wealth by accessing large projects and special development schemes under the umbrella of NEP 1971. Without substantial capital and experience, BUMIPUTERA are more likely to work in consortium, a network of firms where resources and expertise are pooled together, in order to complete the jobs. In some instances, BUMIPUTERA serve as proxies to tender for jobs while NON-BUMIPUTERA provide capital and resources in a joint-venture bid (Heng, 1997). In Malaysia, financial institution is often set up as part of diversification strategy in the development of a large corporate group. FINANCIAL has a positive impact on the growth and expansion of firms because access to funds and capital is made more easily. However, the same competitive advantage is detrimental to firm performance. With the presence of a financial institution, risk is internalised and cash-flow is only circulated within the firms in the same corporate group. Monitoring by financial institutions as creditors is compromised by the presence of the same controller and owner of the corporate group. Firms which belong to the same corporate group operate in an internal market where efficiency in scrutiny is offset by their mutual dependence for survival. The underdeveloped financial sector in the country also contributes to the emergence of corporate group’s internal market. 8 The impact of FINANCIAL on firm performance varies according to ownership types; it might differ between NI firms and firms owned by individuals due to the capability of the former in diversifying risks in different types of market, including foreign markets while the later is more risk averse because their families’ wealth and prosperity are bounded by the performance of their businesses. NON-BUMIPUTERA will have higher FINANCIAL than BUMIPUTERA for their relatively longer-running experience and exposure in the corporate sector and restricted access to domestic funds. Hypothesis 4: Use of FINANCIAL varies according to ownership types. Hypothesis 4a: NI firms have the highest incidence of FINANCIAL. Hypothesis 5: The impact of FINANCIAL on firm performance varies according to ownership types. Hypothesis 6: The impact of FINANCIAL on firm size varies according to ownership types. METHODOLOGY & RESULTS Source of Data The sample used in this study is derived from the listed firms on the KLSE. Information with regards to equity ownership, market capitalisation, and financial performance was obtained from the KLSE Annual Handbook 2001. KLSE requires the disclosure of the identity of shareholder who has a minimum of 2% equity share in a listed company. Definition of Variables Ownership is defined as the amount of equity shares a single party holds in a company. Therefore, it is the concentration of voting rights in examination. Malaysia is found to be among the countries which “impose a genuine one-share-one-vote rule” (Thillainathan, 1999, p.30). La Porta et al. ’s (1999) definition of ultimate ownership is adopted here. The identities and background of major shareholders in a firm is checked. This is performed 9 repetitively if a company is registered as a major shareholder until the ultimate owner3 is found. Information with regards to the relationships among firms and individuals are obtained through various newspapers, journals and magazines through databases such as Dow Jones Interactive, LexisNexis and Proquest. Four major ownership types are identified: Bumiputera-Individual (BUMIPUTERA), Non-Bumiputera-Individual (NON-BUMIPUTERA), Non-Individual (NI), and Sino-Malay Individual (SINO) shareholders – where a firm is co-owned by Bumiputera and Non- Bumiputera owners. This study does not differentiate between individual-owned and family- owned firms as they share similar characteristics in business strategies and organisational structure as compared to firms controlled by institutional shareholders, such as the state, trust fund and foreign firms. Political affiliation is identified by referring to Johnson and Mitton’s (2003) study. Firms are deemed to having political connection4 if their officers or major shareholders are closely associated with a number of prominent government officials, especially Mahathir, Daim and Anwar (Johnson and Mitton, 2003). Since there have been no study examining affiliation with financial institution, this study define affiliation to financial institution as having a financial institution in the same corporate group of which a sample listed company belongs to. To control for size and age of firm, the top 236 listed firms on KLSE are selected, where data is available, based on their ranking according to their market capitalisation and at least 10 years or older in years of incorporation and listing. Firm performance is measured in ROA, a time-series averages5 of the financial information from year 1994-2000 to reduce 3 For more details on ultimate ownership, please see La Porta, R., Lopez-De-Silanes, F. and Shleifer, A. (1999) "Corporate Ownership Around the World", The Journal of Finance, Vol. 54, No. 2, pp. 471-517. 4 For detail description of the political relationships, please see Gomez, E. T. and Jomo, K. S. (1997) Malaysia's Political Economy: Politics, Patronage and Profits, edn.), Cambridge University Press, Cambridge. 5 Average across time for each firm and then determine the mean for the sample by averaging across firms. Anderson, R. C. and Reeb, D. M. (2003),Founding-Family Ownership and Firm Performance: Evidence from the S&P 500, 10 serial correl