Do firms with foreign equity recover faster from financial distress? : the case of Colombia

INDUSTRY AND[ ENEHRGY PL[ PA I MpV7 NV'O)RKINC F '-'F-R INDUS T'R ' S LHIL LF-APLE. R N, ,9 Do Firms with Foreign Equity Recover Fas.ar from Financial Distress? The Case of Colombia December 1991 = . = = . .V . _ . . . . . .. .. .. . . . ._  INDUSTRY AND ENERGY DEPARTMENT WORKING PAPER INDUSTR Y SERIEa PAPER NO. 49 Do Firms with Foreign Equity Recover Faster from Financial Distress? The Case of Colombia DeIcember 1991 The World Bank Industry and Energy Department, OSP  DO FIRMS WITH FOREIGN EQUITY RECOVER FASTER FROM FINANCL41 DISTRESS? THE CASE OF COLOMBIA Izak Atiyas and Mark Dutz The World Bank Industry Development Division December 1991 ABSTRACI' This paper uses firm-level data from Colombia to examine whether firms with foreign equity participation (FDI firms) perform better than domestic firms during recovery from financial distress. We first present evidence that FDI firms that were in financial distress in the beginning of the sample period performed better than domestic firms during recovery in terms of several indicators of earnings and growth. The paper then asks whether better access to external funds was responsible for their superior performance. Estimated investment equations provide evidence that compared to domesti firms, the investment behavior of FDI firms is less affected by financial constraints. Specifically, the negative impact of indebtedness on investment is smaller among distressed FDI firms. Moreover, distresed FDI firms are also less constrained by liquidity relative to distressed domestic firms. These results suggest that financial factors were partly responsible for FDI Firms' faster . :covery from financial distress. Finally, evidence also suggests that differences between domestic and foreign firms are less pronounced in the whole sample of firms than in the restricted sample of financially distressed firms. We thank Claudio Frischtak for helpful comments. The views expressed in this paper are entirely those of the authors and should not be attributed in any manner to the World Bank.  TABLE OF CONTENTS Page No. 1. INTRODUCTION ................................................. I II. GOVERNMENT POLICY TOWARDS FDI .............................. 6 III. INDUSTRLAL ADJUSTMENT AND THE COMPARATIVE PERFORMANCE OF FOREIGN AND DOMESTIC FIRMS IN COLOMBIA .7......... 7 IV. FINANCING CONSTRAINTS AND INVESTMENT BEHAVIOR . . . 12 V. INTERPRETATION OF THE ADJUSTMENT PERIOD ................... 17 VI. CONCLUSION .................................................... 18 REFERENCES ..... . ....... .......................................... 19 TABLES Table I Seclorai Distribution of Firms, 1985 ... 21 Table 2: Performance Indicators by Ownership. 1983-1987 (whole sample) 22 Table 3: Pcrformance Indicators by Ownership, 1983-1987 (distressed firms) 23 Table 4: Increase in Equity by Ownership, 1983-1987 . ... 24 Table 5: Definitiolis of Variables Used in Regressions ........ ... 24 Table 6: Impact of Financial Variables on Investment (distressed firms) . 25 Table 7: Impact of Financial Variables on Investment (whole sample) ........ 26  I. INTRODUCTION 1.01 This paper examines whether firms with foreign equity participation perform better than domestic firms during recovery from financial distress. Contractionary stabilization policies and relative price shifts that characterize periods of structural adjustment often cause financial distress in the corporate sector. During such episodes, firms face financial constraints that are much more binding than normal. In turn, the existence of financial constraints restricts the extent to which firms can resume growth; recent studies have found that limited access to external finance is one of the most serious bottlenecks that constrain investment response during periods of adjustment.' However, the ability of domestic firms and those with foreign direct investment (hereafter FDI firms) to adjust to shocks may differ systematically, depending on the severity of the financial constraints they face. Whether FDI firms have greater access to exterral finance during such periods and whether their investment response is consequently less constrained, are the questions explored in this paper. 1.02 In an environment with perfect financial markets, firms' real decisions would be independenit ef their financing decisions, and firms' investment behavior would not be affected by their financial condition. In particular, financial distress would not in itself impose significant constraints on firm behavior and performance, Providers of finance would be concerned only with the profitability of firms' projects. That is not the case, however, when financial markets suffer from problems of imperfect information and costly contract enforcement. Imperfect information and incentive problems limit t,.e extent to which firms can raise debt financing. Banks cannot perfectly monitor the actions of borrowers after a loan is made. This creates "agency problems" and gives borrowers an incentive to undertake actions that increase the equity value of the firm at the expense of the value of debt. Along these lines. Jensen and Meckling (1986) and Green (1984) have argued that owners or shareholders have incenitives to engage in projects that are too risky, a phenomenon that has been labeled "asset substitution". If the project is successful. shareholders have high returns. AJ For the case of Airica, see, tor example, Frischtak (199(0), liettige, Steel and Wayem (1991), and for Boliveia, sec Dutz. Mierau-Klein and Page (1991).  -2- whereas if the project is unsuccessful, limited liability ensures that creditors bear most of the cost. 1.03 In a similar vein, Myers (1977) has argued that because owners of debt- financed firms are interested in cash flows over and above the repayment of debt, they may forgo projects with positive net present values. Since lenders are aware of these conflicts, borrowers ultimately bear the agency costs in terms of higher costs of debt. The important implication is that agency problems make external funds more costly for firms than internally-generated funds. This, in turn, makes Lirms prefer using internal funds for financing investment.)' 1.04 Periods of financial distress raise additional problems. When distress results in the erosion of the equity base of the firm, agency problems are aggravated oecause the owners' stake in the firms is reduced (Bernanke and Gertler, l990); hence agency costs of external finance increase at the very moment when such finance ma; be especially necessary to enable firms to continue their operations. Moreover, financial distress raises significant coordination problems anmong creditors. Thus, even though it may be . the interest of all creditors as a group to provide relief anid extend credit to the borrower, free-rider problems may prevent ,idividual creditors from taking the initiative (Gertner and Scharfstein, 1991). When information is imperfect, financially distressed firms may find it difficult even to raise trade credit.3 In addition, incentive problems and asymrnetric iriformation between lenders and borrowers can generate credit rationing. Asymmetric information between potent;al investors and incumbent shareholders are argued to cause "equity rationing" as vell. 3/ Firms are likely to experience additional costs during financial distress. For example, customers may be unwilling to buy their goods, fearing that if the good needs servicing in the future, the firmn may no longer be there. The firm, suffering a loss in reputation, may have to spend more resource: to convince trading partners. These factors both increase external finance requirements and costs of external finance. See Cutler and Summers (1988) for empirical evidence on such costs from the US.  - 3 - 1.05 Several features of foreign equity participation may have an effect on the financ1al constraints faced by fimns. The most important attribute of foreign participation is the enhanced possibility of raising equity. Foreign partners, especially those from developed countries, command larger amounts of financial resources and wealth and therefore may find it easier to raise capital from their own resources for profitable projects. This is especially important during periods of financial distress. 1.06 By inrreasing their equity base, firms may also increase their chances of securing further external finance, especially debt. Still, for a given level of indebtedness relative to net worth, two opposing factors affect the agency costs of additional debt faced by firms with foreign equity. On the one hand, foreign firms may rely on reputatijn effects to decrease the cost of debt. On the other hand, forei,,n firms are also likely to possess more unexploited growth opportunities and the possibilities for asset substitution; in particular, FDI firms are m3ore like'y to introduce unique products or processes, or to accumulate intangible capital. As argued by Long and Malitz (1985), it is t. types of firm-specific investment opportunities that are especially prone to agency problF -is. since they allow borrowers more flexibility to change the risk attributes of the project, ai. ' hence are less moniterable by creditors. If foreign firms are indeed more endowed with SLUl growth opportunities, then everything else being equal, they face higher costs of debt. In general, then, the impact of FDI on access to financial resources and investment behavior is an empirical issue. 1.07 Colombia is a country where imperfections in tinancial markets are expected to be especially acute. A liquid stock market does not exist in Colombia. HLnce, retained earnings and owners' wealth are the only important sources of equity financing. Most lending that is free of government interiention is of short matur ty. Moreover, evidence suggests that problerns of imperfect information and costly contract enforcement do impose significant constraints on the financial structures of enterprises.4 Ai For empirical evidence on the importance of financial imperfections in explaining cross-sectional variations in corporate indebtedness in Colombia, see Atiyas (1991).  -4- 1.08 In this paper, we provide empirical evidence on whether domestic and FDI firms in Colombia have been differentially affected by financial constraints during a specific period of recovery after the imposition of structural adjustment policies. We rely on a growing number of studies that have examined empirically how imperfections in financial markets may restrict access to financing. A common approach of these studies has been to divide firms into classes that are a prioriexpected to be affected differentially by financial factors. Typically, these studies augment standard investment equations with financial variables (such as measures of liquidity and indebtedness) that should be irreievant under the null hypothesis that financial markets are perfect. The research strategy is not only to examine the effect of these financial variables but also to analyze how these effects vary across different categories of firms. Along these lines, it has been shown that the impact of financial factors differs according to a firm's size, age, membership in industrial groups, and dividend payout behavior.5' We use a similar approach but focus on the impact of financial factors across domestic and FDI firms. .0(9 We use firm-level financial data for 1983-87, a period that corresponds to the immediate aftermath of a deep industrial recession in Colombia, which is attributed, among other factors, to trade liberalization. We first compare the performance of domestiL and FD! firms; we use various measures of earnings and investment/growth as performance indicators. We then focus on the impact of financial factors on investment behavior to determine whether access to finance helps explain differential performance. To highlight the impact of the adjustment process on firm behavior, we follow the approach of Hoshi, Kashyap and Scharfstein ( 1990a) and pay special attention to those donicst. and FDI firms that suffered financial distress in the beginning of the period. 1.1( The rest of the paper is organized as follows. The next section summarizes governiment policies towards FDI in Colombia. Section III reviews the main macroeconomic developments during the sample period and compares the perforrnance of domestic and FDI -5 See Fazzari, Hubbard and Petersen (1988) on the US, Devereux and Schiantarelli (1989) on the UK, and Hoshi, Kashyap and Scharfstein (1990b) on Japan.  firms. In Section IV, econometric evidence is provided on whether the effect of financial factors on investment behavior differs across domestic and FDI firms. Section V relies on these econometric results to interpret the reasons underlying the superior performance of FDI firms during recovery. Section VI concludes the paper.  -6- II. GOVERNMENT POLICY TOWARDS FDI 2.01 In the 1950s, promotion of FD! was an important component of the Colombian government's policy of import substitution, especially in intermediate and capital goods industries. It is estimated that between 1957 and 1964, FDI accounted for 20 to 30 percent of manufacturing industry investment. Following the balance of payments crisis in 1966, the Colombian government began to undertake measures to limit FDI. In 1967, as part of this new approach, annual profit remittances of foreign firms were restrictea to 14 percent of their investment. sn 1970, as pa. t of the Andean Group's effort to coordinate industrial policies, maximum foreign ownership was reduced to 49 percent. 2.02 However, during the recession of the early 1980s, restrictions towards FDI were eased. In 1983-84, profit remittances were increased to 50 pervent for priority sectors (mainly heavy industry and exports), geographical restrictions on location were suspended, and the possibility of reinvesting earnings v as expanded. The FDI reginie was further iiberalized in 1987 through amendments to previous Andean Pact legislation. 2.03 FDI has remained concentrated in highly capital- and skill-intensive industries. For example, in 1989, 57 percent of cumulative foreign direct investment was in chemicals, paper, rubber, plastics, electrical machinery, and transport equipment. .~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ For a summary of Colombian policies towards FDI, see World Bank (1990a) and Wallace (1987).  III. INDUSTRIAL ADJUSTMENT AND THE COMPARATIVE PERFORMANCE OF FOREIGN AND DOMESTIC FIRMS IN COLOMBIA 3.01 The recession of the 1980-82 period resulted from the interplay of several factors."' The government responded to the coffee boom of the mid-1970s with a contractionary macroeconomic program. Public expenditure wa