Positive Relationship between Corporate Governance and Economic Performance - Report Example

Relationship between Corporate Governance and Economic Performance [Name] [Professor Name] [Course] [Date] Positive Relationship between Corporate Governance and Economic Performance Abstract: Corporate governance comprises the set of processes, practices or rules applied in directing and managing a company. Basically, it includes all the activities that are aimed at ensuring the stakeholder interests are balanced. Given that it also offers the structure for achieving a company’s objectives (Harjoto and Maretno 2012). The concept of corporate governance is extensive and covers essentially every aspects of management, including the company’s external and internal controls as well as the action plans, corporate social responsibility and performance metrics. Nevertheless, despite the type of business, economists tend to agree that effective corporate governance can ensure sustainable financial performance. This paper provides a comprehensive literature review of the research studies that attempt to illustrate the positive relationship between corporate governance and economic performance. Keywords: Corporate governance, economic performance, corporate social responsibility, Introduction The fundamentals of the relationship between corporate governance and economic performance have recently elicited a hot debate in Australia and across the globe. The sudden focus has been amplified by the ever-rising section of the market portfolio dominated by private pension funds or mutual funds that have raised curiosity on whether investors in the corporate should maintain their role as passive owners or exercise their authority to more actively control the managers of the companies where they have invested. The concept of corporate governance mechanisms is wide and has been noted by Harjoto and Maretno (2012) to include concentrated ownership, characteristics of the board, design of the security, insider and outsider ownership, market competition and types of owners. It is viewed as a set of rules that describe the relationship between the corporate management and the stakeholders. Further, it influences the way in which the company is operated. However, it goes beyond the relationship between the management and the shareholders as its impact is also integral to the economic performance of the nation. The subsistence of effective governance can have a positive impact on the economic performance of the company and the immediate society at large. Indeed, it is through this notion that some theorists have tended to relate corporate governance and the economic performance of a nation or a company (Marcus 2010). Therefore, the diversity of the areas covered in corporate governance and its relationship with economic performance calls for a thematic approach. Using this approach, corporate governance is perceived as encompassing macro-governance (such as broad stakeholder issues and capital markets) and micro-governance (such as ownership and management of the firm). The performance issues are at two levels, such as the aggregate country-level and the firm-level economy (McGuire, Dow, Sandra and Bakr 2012). Cross-country level It is widely established that efforts at the country level to exercise political and legal reforms can have substantial impact on the management and control of a company. Both are rationalized by the fact that effective legal and political governance would ensure contractual integrity as well as develop of financial market development and financial capital inflow. This would as a result offer significant external corporate governance to the companies through scrutiny of the market, thus ensuring there is an effective environment for financial growth (Perrini et al 2011). Overall, it therefore appears that corporate governance is essential for economic performance at the country level. Economists are interested in corporate governance as it has the potential to influence the economic significance of a society’s resources in a positive way (McGuire, Dow, Sandra and Bakr 2012). Since the performance metric is expected to reflect the creation of this value, the potential factors are important. For example, in the event of high employment rates, economists may tend to focus on contributory measures such as the employment rates or investing on fixed assets. Perrini et al (2011) have attempted to explain the significance of corporate governance in the emerging economies. It is established that the importance of corporate governance can be explained through the creation of institutions that control the transformation of the economy based on the market. Others include purposeful allocation of capital as well as the creation of a financial market, next contribution to the overall national development and lastly, attraction of foreign investors. Juelin and Yuli (2007) observe the desire to have a more critical perspective to fully understand the benefits of corporate governance to the developing or marginalized nations. In their analysis, the most influential proponents of corporate governance have originated from economic development literature. Several attempts have been made to demonstrate corporate governance as a contributory factor to the economic and social development of these nations as well as its role in the alleviation of poverty (Wagner 2010). Indeed the contributors to such claims have pointed out that there is the need to have a critical approach to monitor the strengths and limitations of controlling and making decisions in the firms (McGuire, Dow, Sandra and Bakr 2012) Nuttaneeya, Wayne and Hecker (2012) have further explained that mechanisms of corporate governance can ensure growth and development of a nation’s economy. These mechanisms include finance and investment and corporate social responsibility (CSR). Corporate Social Responsibility, s a form of corporate governance, has proved effective in ensuring enhanced improved performance. Indeed, it is among the variables that have proved significant in ensuring sustainable development, such as social frameworks. Thus, restoration of stakeholder confidence through corporate governance is vital in promoting development in the economies. With this regard Price et al (2011) posits that corporate integrity promotes strengthened market discipline, which consequentially prompts transparency as a result of improved disclosure. Towaru (2011) has identified three variables that can promote growth of national economies. These include competitive resources, effective macroeconomic fundamentals and responsible and stimulant companies. A growing body of researches has thus tended to relate the effectiveness of corporate governance and the impact on economic performance of the firm. In fact, most of the proponents of this school of thought have demonstrated that among the most significant contributors include having a healthy economic climate and having effective practices of corporate governance (Werder 2011). Firm-level evidence At the firm level, the positive relationship between the corporate governance and economic performance can easily be illustrated using the agency theory. Corporate governance can promote profitability of companies, hence bringing value to the firm. The theory is widely accepted as the predominant theoretical concept applied in research on corporate governance. It encompasses issues such as the separation of ownership and control of the company (Parker 2005). a) Return on Investments Tiwari (2010) suggests that corporate governance plays special role in promoting improved economic performance of companies, as they provide a mechanism that substantially impacts returns on investment. Price et al (2011) illustrates that corporate governance should as well set out a set of market mechanisms that can enable managers of the company to optimize the significance of residual cash flows of the company to the shareholders. It is further noted that if most of the domestic markets (such as capital markets, goods or labor) work resourcefully, then optimal possible growth rate of the company can be attained. Further, attaining the optimal possible growth is not exclusively the ultimate goal as maintaining the growth is what is more important. Tiwari (2011) notes that effective corporate governance can be essential in ensuring that these conditions are maintained, thus sustained economic performance in the long run. Based on the agency theory, it can be argued that corporate governance can play a vital role in reducing the agency costs. In explaining the concept of corporate governance, Mueller (2006) illustrates the existence of the principle-agent relationship within the company. In relating corporate governance with economic governance, economists have often associated the agency problem -- or principal-agent. The principal-agent relationship comes about when the owner of the firm is different from the manager of the firm. This situation can be explained by a situation where the principal (financer or investors) employ agents (managers) to direct the firm. In this case, the principals need the agents to generate returns in investments, while the agents need the principals for financial security. In such as case, there is a disjoint between management and financing. The theory therefore perceives the managers as capable of maximizing the profits and shareholder wealth. The theory further postulates that the managers are also the sole owners of the company and that the company is solely interested in profits. Under the circumstances that the manager is also the owner of the company’s shares, then the company can be motivated towards maximizing the wealth of shareholders through allocation, efficiency and production. In short, the company’s major objective is to make profit. The measures by which performance is determined can simply assumed the shareholder value (or market value) of the company. This means that manager of the company have are obligated to ensure that firm are operated in the interested of the shareholders. Therefore, an effective corporate governance structure has the capacity to reduce the agency costs and delay problems that are associated with separation of the control and ownership of the company. In all, three types of mechanism can be applied in aligning the objectives and interests of the shareholders with those of the managers to overcome issues associated with managing the company. These include, motivating the managers to control the company efficiently, through aligning their interests with those of the manager directly, and fortifying the rights of the shareholders thus enabling them to have be greatly motivated to monitor the management of the company. Lastly, applying indirect means of controlling the company, for instance through managerial labor markets. b) Stakeholders Perrini et al (2011) posit that the potential economic benefits that corporations can derive from corporate governance has two origins, namely the expectations held by most influential stakeholders of the company, including the consumers, investors and employees and the major driver behind the adoption of the kind of governance by the company, which is often threatened by the likelihood that the state can impose new regulations on the industry. Most theoretical approaches tend to have a direct link between the economic performance of the firms and the corporate governance depends significantly on the ability of the company to influence stakeholders, such as the consumers. Accordingly, effective corporate governance can change consumer behavior and consequently affect the corporation’s economic performance. It is further argued that effective corporate governance can sell the company’s image as a result enabling the consumers to be more aware of the company, its products and performance. This has the effect of increasing the firms’ sales output as technically, it can be argued that the change in customer attitudes can influence customer loyalty. In effect, this has the capacity to improve the economic performance of the corporation (Parker 2005). Tang (2008) argues that the relationship between corporate financial performance (CFP) and corporate will still remain controversial amid substantial amounts of researchers. According to his argument, the positive impact of corporate governance can further improve the relationship between the company and the stakeholders as a result improving the relationship between the company and the employees, regulators, suppliers and customers. Tang (2008) continues to point out that the consistent engagement in corporate governance between the stakeholders and managers enables companies to more strategically plan their expansion schemes (Weitzner and Peridis 2011). Tang (2008) uses the path dependency theory to point out that companies that use effective management strategies consistently are able to amass and accumulate complementary resources in more methodological manner and to show the stakeholders an image of serious governance. In this way, a consistently effective control and decision-making of the company can be very instrumental in helping the company to benefit economically (Parker 2005). c) Competitive Industry Based on this perspective, it is perceived that corporate governance can serve as an equilibrating instrument for efficiency that ensures that the company responds to changes in the economic patterns. For instance, it can provide a check for the management and decision-making of the firm, as everything is working well. This has the effect of transforming the image of the firm. Yet again, some literature portray effective corporate governance as an indicator of product quality, and that they are more beneficial to the more competitive industries that invest hugely in advertisements. Their proposition is derived from a simpler approach where corporate philanthropy can be used as a mechanism that depicts quality of company products. In this way, firms that are generally profit-oriented are able to increase their sales and overall revenue. This kind of argument has been replicated by theorists who believe that corporate governance can be more valuable in competitive industries where opportunity to signal quality exists. With this regard, they adopt intensified advertising which has the capacity to increases sales, as the proxy depicting quality products (Werder 2011). Conclusion Overall, it can be concluded that the concept of corporate governance, in its varied manifestations such as corporate social responsibility, is likely to play an important role in the reduction of poverty. From this perspective, indeed it can be argued that a corporation can in this way attain a good reputation for profitability while managing to remain socially responsible (Parker 2005). Empirical researches focused on understanding the relationship between corporate governance and economic performances have thus far been limited. Partly, this is since corporate governance is still a new field of study and hence has undeveloped theory basis, and also because quality data on this phenomenon is difficult to obtain. However, the premise underlying the interaction between corporate governance and economic performance is that governance is crucial (Mueller 2006). References Hoje, J & Harjoto, M. 2012. “The Causal Effect of Corporate Governance on Corporate Social Responsibility.” Journal of Business Ethics, Vol.106(1), pp.53-72 Jinghui ,L. & Taylor, D.2008 "Legitimacy and corporate governance determinants of executives' remuneration disclosures", Corporate Governance, Vol. 8 Iss: 1, pp.59 – 72 Mueller, D. 2006. “Corporate Governance and Economic Performance.” International Review of Applied Economics. Vol. 20, No. 5, 623–643 McGuire, J, Dow, S., Bakr, I. 2012. “All in the family? Social performance and corporate governance in the family firm.” Journal of Business Research, Vol. 65(11) Nuttaneeya, T. Wayne . O. & Hecker, R. 2012. “Capabilities, Proactive CSR and Financial Performance in SMEs: Empirical Evidence from an Australian Manufacturing Industry Sector.” Journal of Business Ethics, Vol.109(4), pp.483-500] Parker, L 2005. "Social and environmental accountability research: A view from the commentary box", Accounting, Auditing & Accountability Journal, Vol. 18 Iss: 6, pp.842 – 860 Perrini, F., Russo, A., Tencati, A &Vurro, C. 2011. Deconstructing the Relationship Between Corporate Social and Financial Performance. Journal of Business Ethics, Vol.102(1), pp.59-76 Price, R., Román, F., & Rountree, B. 2011. “The impact of governance reform on performance and transparency.” Journal of Financial Economics, 2011, Vol. 99(1), pp.76-96 Tiwari, A. 2010. ''Corporate governance and economic growth.” Economics Bulletin, Vol. 30 no.4 pp. 2825-2841 Wagner, M. 2010. “The role of corporate sustainability performance for economic performance: A firm-level analysis of moderation effects.” Ecological Economics, Vol.69(7), pp.1553-1560] Werder, A. 2011. “Corporate Governance and Stakeholder Opportunism.” Organization Science, 2011, Vol.22(5), p.1345-1358 Weitzner, D. & Peridis, T. 2011. “Corporate Governance as Part of the Strategic Process: Rethinking the Role of the Board.” Journal of Business Ethics, Vol.102(1), pp.33-42 Yin, J. & Zhang, Y.2012. “Institutional Dynamics and Corporate Social Responsibility (CSR) in an Emerging Country Context: Evidence from China.” Journal of Business Ethics, Vol.111(2), pp.301-316 Read More