Foreign ownership and investment: evidence from Korea

Abstract

This study examines whether an increase in foreign ownership affects investment in Korea. Many studies have shown that in an imperfect financial market, a firm's investment depends on the availability of internal funds. If high foreigners’ shareholding is a sign of a firm's good financial position, and if foreign investors demand better corporate governance to protect their investments, then cash-flow sensitivity of investment decreases with the level of foreign ownership. Using data from Korean firms, it is found that cash-flow sensitivity of investment is lower in firms with high foreign ownership than in those with low foreign ownership. This finding is regarded as evidence for a potential benefit of open financial markets.

Acknowledgements

The authors appreciate the participants at the Pacific Rim Conference held at Hong Kong in 2005 and the editor for their comments

Notes

¹ Stein (2001) reviews the relevant theoretical literature.

² Two classes of models suggest opposite implication on the desirability of current investment level. The first model predicts underinvestment while the second one predicts overinvestment. As Stein (2001) states, there have been very few attempts to distinguish empirically between the two classes of theories.

³ Schiantarelli (1996) and Hubbard (1998) provide extensive surveys of empirical literature, mainly focusing on the financial constraint model.

⁴ For detailed derivation of the model, refer to Forbes (2003).

⁵ Refer to Forbes (2003) for a complete description of weaknesses of the q-model.

⁶ This model ignores the possibility of debt financing. As Love (2003) describes, the inclusion of debt financing, however, does not affect the first-order condition for investment. We may have another Euler equation for debt in a model that includes debt. Because the optimal debt level is out of the scope of this study, the Euler equation for investment suffices.

⁷ Gilchrist and Himmelberg (1999) show that, if a production function has a Cobb–Douglas form, the marginal product of capital is proportional to sales.

⁸ Hayashi and Inoue (1991) argue that many explanatory variables of investment such as output and cash flow depend on technology shock, and are thus endogenous as well.

⁹ Firms that were listed for less than five years and firms that did not have values available for any of relevant variables were eliminated.

¹⁰ Average foreign shares for all sample firms during the whole period are 5.88%. There are no different results, although the other criterion was applied, such as one-thirds, the upper three quartile, and the half.

¹¹ The Korean economy experienced a crisis at the end of 1997. Firms’ investments decreased dramatically due to a sustained economic slump and the implementation of strong financial restructuring programmes after 1998.

¹² It is noted that studies using data from Korean firms, like Laeven (2002), and Koo and Shin (2004), also adopt the GMM-level estimation technique because the individual firm effect was found to be weak.

¹³ Koo and Shin (2004) claim that financial constraints significantly decreased after 1996 in Korea because of financial liberalization, including the opening of the stock market.

¹⁴Hadlock (1998) finds evidence for the non-linear relationship between ownership structure and financial constraints.

¹⁵ For example, Park (2002) documents a significant curvilinear relationship between Tobin's q and the fraction of stocks owned by foreigners in Japan. q rises until foreign ownership reaches 40–45% then falls back. Similarly, Al-Khouri et al . (2004) find a non-linear relationship between firm value and foreign ownership in Jordan.