Legal Investor Protection, Product Market Competition, And Corporate Performance

How to improve corporate performance is the common issue of both the theoretical and practical field. But for a long time, the role of law has not been given sufficient attention. Until the last decade of the twentieth century, La Porta et al. began to study business issues from the legal point of view. They established the theory of law and finance and yielded a rich harvest. It is showned that better legal investor protection is associated with lower private benefits of control, more developed capital markets, lower cost of capital and higher valuation of firms. However, most of these studies excluded China. As an emerging and transition economy, China has a poor legal system and the imcompleteness of law is obvious. The evolution of law is objective and deeply rooted in the nation's law tradition and culture. So it is impossible to establish a developed legal system in a short time. One question we must answer is that how to promote economic growth and improve corporate performance in such a condition. Allen et al. (2005) noticed that China's legal system is significantly under-developed and even not ahead of other major emerging economies. Nevertheless it has one of the fastest growing economies in the past three decades. Besides law, what mechanisms supported the miracle of China? Product market competition is probably the most powerful force toward economic efficiency in the world (Shleifer and Vishny, 1997). What is the impact of product market competition on corporate performance in China? What is the interaction relationship between legal investor protection and product market competition? The answers to these questions supplement the theory of law and finance and the competition theory and is of great importance to the reform and economic growth of China.The previous research usually study the impact of legal investor protection or product market competition on corporate performance respectively and focus on only one aspect of corporate performance. This paper put legal investor protection and product market competition in one framework, study their governance performance and their impact on investment performance and accounting performance. There is a logical connection among these performance. Governance performance is the effect of legal investor protection and product market competition on reducing the agency cost. Governance performance is in the basic position. Legal investor protection and product market competition affect investment performance and accounting performance by mitigating agency problems. Financial decision making performance is the link between governance performance and accounting performance. In this paper, investment performance is used to represent financial decision making performance. Accounting performance is the result of the overall operation of the firm.Main findings of this paper are as fellows.(1) In respect of governance performance. The improvement of legal investor protection can reduce the angency cost of firms obviously. However the governance performance of law is different in firms with different nature of ownership. The improvement of law on paper has a more powerful impact on reducing agency cost of state owned enterprises, which indicates state owned enterprises are more likely to abide by law consciously. Strengthening law enforcement can reduce the first type agency cost significantly in both state owned enterprises and non-state owned enterprises, but for the second type of agency cost which is indicated by the controlling shareholder's embezzlement, it has significant governance impact only in non-state owned enterprises. The main reason for this is that China's judicial system is lack of independence. The enforcement of law is ofen influenced by government. State owned enterprise has a close relationship with the government. They carry more social responsibilities and political burden and will also enjoy more shelter from the government. For the regional economic benefits or private benefits of the government officials, the government even has the motivation to support the state owned listed companies to misappropriate money in the security market. Moreover, we have the legal tradition of protecting state owned assets and neglecting private property rights, which will bring bias to law enforcement.Product market competition also has significant governance performance, especially in state owned enterprise. State owned enterprises have problems such as absence of property rights, lack of managerial incentives and ineffectiveness of internal governance. So the disciplinary forces of product market competition is of greater importance to state owned enterprises. Legal investor protection and product market competition solve the agency problems together and they may have interaction relationship. Legal investor protection can play a greater governance role in less competitive industries. To make the product market competition have governance performance, certain level of law is needed. Our legal system is still under-developed and so the empirical results show that the governance performance of the product market competition only significantly exists in the situation that the level of legal investor protection is relatively high.(2) In respect of investment performance. The improvement of legal investor protection and an increase in product market competition can both enhance the investment performance of the enterprise significantly. However, the pathway is not the same. Legal investor protection's impact is mainly to restrain over-investment, but product market competition's impact is mainly to restrain under-investment. That's because the level of legal investor protection is still relatively low and the product market competition is imperfect in our country. So both legal investor protection and product market competition have not played their full role in enhancing the investment performance. At present, taking a step further to improve legal investor protection and increase product market competition could enhance the investment performance of enterprises from different ways. Further research also shows that legal investor protection and product market competition's impact on investment performance is significant only in state owned enterprises. There is also an interaction relationship between legal investor protection and product market competition in improving investment performance. When legal investor protection is weak, the problem of under-investment is more serious and product market competition has a more significant impact on enhancing the efficiency of investment. Product market competition restrains under-investment, at the same time, enterprises may have the tendency of over-investment in order to obtain market share in the highly competitive industries. The impact of legal investor protection on restraining over-investment is significant in such industries.(3) In respect of accounting performance. The improvement of legal investor protection is useful in enhancing the accounting performance of enterprises. However segmented regression analysis shows that the improvement of law is not the"quick-acting medicine". Legislation has positive impact on accounting performance only when it is above certain level. Legal investor protection could improve the corporate performance mainly through mitigating agency problems. In less competitive industries, disciplinary forces of market are weak and the agency problems are more serious. Legal investor protection's positive effect on accounting performance is more significant. The effect of increasing product market competition on accounting performance depends on the comparison of fewer monopoly rents and fewer agency cost. Empirical results give support to the negative relationship between industry competition and accounting performance, which indicate that the reduction in monopoly rent is greater than in agency cost. This negative relationship between product market competition and accounting performance is significant only in the state owned enterprises.In summary, the results of this paper support the law and finance theory and competition theory. However, China is an emerging and transition economy, the effect of legal investor protection and product market competition has something special. improvement of law is the basis for increasing corporate performance. So the design and enforcement of law should be prometed continuously. To improve the law will be a long process. Other mechanisms shuch as product market competition is also of great importance. The close fit between law and other mechanisms appears to be crucial for improving corporate performance.