Foreign Ownership and Investment: Evidence from Korea

1. Introduction
§ Korean equity market → opened to foreign investors in January 1992
§ Maximum foreign investment limits → eliminated in May 1998
§ Effects of increase in foreign ownership → attract many attentions
§ Researches found → firm’s investment depends on the availability of internal funds
§ The importance of financial factors → is attributed to higher costs of external finance arising from information asymmetry and agency costs in an imperfect capital market
§ This study → focuses on the level of foreign ownership as a segmenting criterion
§ If financial intermediaries consider that foreigners favour firms with low information asymmetry → firms with high foreign ownership are able to raise external funds at low cost
§ If foreign investors have better monitoring skills than domestic investors in developing countries → foreign firms have less managerial agency problems
§ Test whether firms owned by foreigners face less credit constraint than domestically owned firms → main empirical findings:
i. Cash flow sensitivity of investment ↓ as foreign ownership ↑
ii. After 1998 → effect on foreign ownership on financial constraints became stronger

2. Relevant Literature and Hypothesis Formulation
§ Modigliani and Miller → Firms investment depend on the profit opportunity
§ Empirical literature → found that firms’ investment decision depend on financial factors → availability of internal funds
§ Why investment is sensitive to internal funds in imperfect financial markets → two streams:
i. Focus on lemon premium → firms must pay on external finance → firms tend to rely internal funds to carry out performance
ii. Studies attribute the importance of internal funds to managerial agency problems
§ Managers → not the owners → may pursue their own interest → not the stakeholders’ interest
§ Managers tend to spend all available funds on investment projects at their own discretion
§ Both stream of literature predict → the availability of internal funds does affect investment
§ Investment of more financially constrained firms respond more sensitively to changes in cash flow
§ Concentrated ownership → leads to less liquidity-constraint
§ Managers’ ownership stakes in their firms increase → investment-cash flow sensitivity increase
§ Cash flow sensitivity decrease → after a certain level of insider holding
§ Most developing countries →have recently experienced an increase in the equity share of foreigners
§ FDI → eases credit constraints by bringing in capital
§ Ivory Coast → foreign firms were less credit-constrained than domestic firms
i. FDI → reduces firm-level financing constraints
§ Present study → examine whether financial constraints are mitigated as a result of a favorable financing position in market
§ Foreign investors prefer → equity shares in firms with low information asymmetry to those with higher information asymmetry
§ Japanese market → Foreigners prefer large firms, firms with good performance, low risk, and low leverage
§ Swedish firms → foreigners prefer large firms, firms paying low dividends, and firms with large cash position
§ Czech firms → foreign investors seek safe and profitable firms where they can exert influence on corporate governance
§ Financial constraints model and managerial discretion model → one expect cash floe sensitivity of investment to be lower in foreign owned firms than in domestically owned firms

3. Model and Method
§ Model
i. q is the only determinant of investment and no other financial variable should matter
ii. A test for existence of financing constraints amounts to a test for null hypothesis
iii. Test → whether cash flow sensitivity of investment differs across foreign ownership structure
iv. Test → whether the complete opening of the Korean equity market has effected the degree of financial constraints
v. q model has many limitation → difficult to measure q → because average q is equal to marginal q under strict condition
vi. Forbes → derived an Euler equation
a. From the model of maximization of the firm value → under the assumption that dividend must be non-negative
b. Implying that external financing is costly due to information asymmetry
§ Method
i. OLS for dynamic investment models → result in biased estimates → because of endogeneity and heterogeneity problems
ii. Sales and cash flow depends on technological shock
iii. The presence of lagged investment-to-capital ratio as an explanatory variable → bias the coefficient estimates from the OLS
iv. The generalized method of moments (GMM) estimation → widely used for dynamic panel model → depends:
a. On the adoption of appropriate instruments
b. On the efficient elimination of unobserved firm effect
v. Arellano and Bond → two specification tests:
a. A Sargan test for over identifying restriction → used to test for the validity of instruments
b. A test of serial correlation of errors terms → used to detect the presence of unobserved individual effect
§ Data and definition of variables
i. A firm-level panel data set → constructed from the Korea Investors Service-Financial Analysis System
ii. Data set → consist of 5084 observations of 371 firms used → period 1992-2002
iii. High foreign ownership → based on two criteria:
a. More than 5.88% foreign ownership
b. More than upper quartile foreign ownership
iv. The dummy variable High → has a value of one for firms with high foreign ownership and zero

4. Empirical Result
§ Sargan test result for over-identifying restrictions → indicate that the instruments used are valid
§ q-model and Euler equation → suggest that:
i. The availability of internal funds does effect investment levels
ii. Persistence is found in a firm’s investment from significant estimates in the lagged investment-to-capital ratio
§ q-model and Euler equation → the cash flow sensitivity for firms with high foreign ownership is statistically insignificant
i. It suggest → financial constraints faced by firm decrease as foreign ownership increases
§ Managers of a firm with high foreign ownership → less likely to use cash flow at their discretion due to improving corporate governance system
§ In the Korean Stock Market → found that estimates in cash flow are lower after 1998
§ It is conjectured → the opening of the stock market is surely one of the factors in the mitigation of financial constraints
§ Found → liquidity constraints are reduced in firms with low foreign ownership
§ Cash-flow sensitivity in firms with high foreign ownership → statistically insignificant regardless of time period
§ Liquidity constraints → not statistically significant in firms with high foreign ownership
§ With non-linear relationship between foreign ownership structure and the value of the firm → foreign ownership seems to have a linear relationship to financial constraints