KRASOVICKIS- 100117156

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BUS211
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GOVERNANCE AND BUSINESS STRATEGY ModuleTitle

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KRASOVICKIS- 100117156 Assess and critique the measures that have been developed to capture the effects of governance on firms and countries performance In the world of business assessing performance of a country or even a firm is of utter importance. We shall be examining the ways in which one can assess a countrys and a firms performance in their environment and discuss whether or not these ways are appropriate and also provide a critique of these indicators. Before we can start assessing and critiquing the measures that have been developed to capture the effects of governance on firms and countries performance we first have to define what governance is. Governance is the way in which an institutional body is directed and controlled. Secondly we have to look at the importance of these measurements and their results. Measuring the effects of governance on performance is important because it provides an idea to potential investors of the business environment that is present and may be encountered if having business relations within that country. Now that we have looked at the importance of these measures we will look at the most commonly used indicators that assess the effects of governance on performance within a country or firm. The most commonly used indicators to measure the effectiveness of governance in a worldwide context are the following, a brief summary will be provided in brackets for each indicator and we will discuss them each in turn: voice and accountability (refers to the freedom of speech, civil liberties, the processes by which representatives are elected and replaced, present within a country. Essentially it shows whether the people have the power to make a change within the country), political stability and lack of violence (refers to the likelihood of usurp of the government through violent means, revolution, etc.), government effectiveness (alludes to the kind of policies implemented by governments and quality of provision for public services), regulatory quality (refers to the amount of bureaucratization present within the business environment and whether the government is likely to interfere with the business environment), rule of law (refers to the ability to enforce contracts, crime rates present, property rights, etc.), and control of corruption (refers to the amount of corruption present and whether its presence affects the business environment in a significant way). All the indicators listed previously are relevant and justified as being the most popular when assessing the effects of governance on performance of a country or firm because there is a high correlation between these factors and the attractiveness of the business environment within a country or firm. For example when investors look at potential economies to invest in they will look at countries which have high voice and accountability, political stability, government effectiveness, and rule of law. The reason being that these factors provide a higher sense of security on the investment. This is supported by Globerman and Shapiro.1They have written a paper, which looks at the relationship between 2

KRASOVICKIS- 100117156 infrastructure (represents legislation, regulation and legal systems) and rates of U.S. FDI (foreign direct investment). In their paper they state: The results indicate that countries that fail to achieve a minimum threshold of effective governance are unlikely to receive any U.S. FDI. Countries that receive no U.S. FDI are typically countries that do not promote free and transparent markets, have ineffective governments, and are often countries whose legal systems are not rooted in English Common Law. Investors will seek countries with low rates of corruption as the business environment is unfair, and they cannot foresee what will happen with investment and low rates of regulatory quality because high amounts of bureaucratization signify lots of government intervention which interferes with business organization. The same paper can also support this statement: U.S. investors tend not to locate in developing and transition countries where corruption is high. These indicators are good for measuring the performance of a country or a firm and do provide insight as to what kind of business environment is present, but that is not to say they are without drawbacks. The way this information is collected is in two ways. One is the poll of experts; the drawback related is that experts all have different motives and thus the quality of information provided may vary from country to country. The second way is through surveys; the drawback associated is that people may carelessly fill in information that will bring its quality down, and since there is a high amount of information that needs to be processed it may be interpreted in culture specific ways. The shortcomings of these indicators also include the fact that they are not very easy to measure and the data provided for each indicator is an estimate. Therefore margins of error will be present and thus the reliability of data diminishes. This is reinforced by Kaufmann and Kraay2 who have studied the 2009 WGI (Worldwide Governance Indicators) results and use them for cross-country comparisons. They state: The aggregate indicators we construct are useful for broad cross-country and over-time comparisons of governance, but all such comparisons should take appropriate account of the margins of error associated with the governance estimates. It is also stated by Kaufmann and Kraay that is nigh impossible to measure corruption: This is most particularly so for the case of corruption, which almost by definition leaves no 'paper trail' that can be captured by purely objective measures. Thus the most prominent critique is the difficulty of acquiring relevant data and the possibility of it being poor and unreliable. Another area where these measures may be critiqued is that the data that is presented in numerous papers does not necessarily reflect on what occurs in reality. That is to say using the indicators provides investors with an idea where it is more favorable to invest in but there are still occurrences where investment occurs in non-favorable business environments and vice-versa. A prime example of this would be China. China is largely considered to be a socialistic country. This means that the economy is not transparent and the government controls the business environment. Even though all these unfavorable factors are present, there has been a large amount of FDI present in China in recent years. This is 3

KRASOVICKIS- 100117156 supported by Fung3 who states: China has become one of the most important destinations for crossborder direct investment. This anomaly is also considered by Globerman and Shapiro who justify it by asserting that: In this regard, Zhang (2001) argues that Western FDI in China is motivated by its comparative political stability. Another example of a country whos indicators suggest an unfavorable business environment is Russia. Russias WGI results provided in the article by Kaufmann and Kraay show that Russia has high rates of corruption, low voice and accountability, political stability and violence, and government effectiveness. Yet statistics show that FDI has been increasing from $13.7 bn (2007) to $27.8 bn (2008)4. We must also consider other measures present that may provide investors with an idea of the business environment in a country. Examples would be GDP (gross domestic product), literacy rates, infant mortality rates, HDI (human development index), and Gini Coefficient. All these measures listed provide insight into the state of a country and may be used with the WGI in a complementary manner or as an alternative. These indicators can be considered effective when measuring the effects of governance on a countrys performance because for example GDP provides insight as to how many goods and services are produced in the country over a period of time. This may reflect on the standard of living, employment rates, and where a country stands financially. Countries with higher GDP will be seen as more attractive to investors. Literacy and infant mortality rates provide insight as to how efficient is the government in providing education and health care to the people which is linked with government effectiveness. HDI provides an idea of how well people live within the country which can be linked to political stability and government effectiveness. The Gini coefficient raises an investors awareness of the equality in a country which can be linked with corruption. In conclusion we have seen that the WGI indicators are good measures that do indeed capture the effects of governance on firms and countries performance. They provide a good idea of the business environment that potential investors will face when looking to venture into a country. We have also discussed each measure in turn and why they are effective at capturing the effects of governance. Even though the indicators perform their task efficiently that does not mean one should not question their validity as well. As we have seen there are drawbacks associated with using these indicators, the main ones being the fact that the data provided are estimates and thus have a margin of error and their reliability may be decreased. This is enforced when we look at the anomalies present with countries such as Russia and China who statistically should be unfavorable countries to invest in but in reality their FDI inflows have seen steady increases in the past years. In addition we also have to consider that these indicators are not the only ones present which may provide insight into the business environment of a country. The WGI do have their flaws but we have to take into account that their duty is only to provide an idea of what the business environment is supposed to be like, which the investors consider and then act 4

KRASOVICKIS- 100117156 upon on their own choice; nothing more nothing less.

KRASOVICKIS- 100117156 References: 1) Globerman, S., Shapiro, D., Governance Infrastructure and U.S. Foreign Direct Investment (2002) 2) Kaufmann, D., Kraay, A., Governance Matters VIII (2009) 3) Fung, K. C., Foreign Direct Investment in China: Policy, Trend and Impact 4) Foreign Direct Investment in Russia: A survey of CEOs (2008) link to paper: http://www.fiac.ru/files/fiac_survey_2008_eng.pdf accessed on 27/02/12