Journal of Accounting and Finance Research Vol. 13, No. 4 October 2005 pp.: 145 – 167
STOCK MARKET LIBERALIZATION AND THE COST OF CAPITAL: EVIDENCE FROM JOHANNESBURG STOCK EXCHANGE (JSE) LISTED FIRMS DANIEL MAKINA AND MINGA NEGASH ABSTRACT: We provide firm level analysis of the impact of stock market liberalization on cost of capital for a single emerging market, South Africa, which liberalized its stock exchange in the 1990s. Our main findings are three-fold. First, consistent with other empirical findings, the majority of firms in our sample show a decline in the cost of capital following liberalization. Secondly, we find the impact of liberalization to be transmitted across all sectors and thus independent of the sector to which a firm belongs. Thirdly, we find a sizeable number of firms that experience an increase in the cost of capital following liberalization, thus indicating an informational effect that negatively re-rates firms by repricing their risk and raising their cost of capital.
INTRODUCTION nternational asset pricing models predict that the integration of capital markets leads to a reduction of the cost of capital as risk is internationally diversified. Empirical studies using market level analysis by Bekaert and Harvey (2000), Henry (2000), Kim and Singal (2000), and others that have examined emerging market stock market liberalization and its impact on the cost of capital support these predictions. However, there could be limits to diversification benefits or gains from integration so that from a general policy perspective, it is also important to examine the microeconomic dimension. That is, whether these benefits only accrue to the few large and well-known firms preferred by foreign investors or they do trickle down to all firms, large or small, and to all sectors of the economy. An important phenomenon that has been shown to be a product of liberalization is the repricing of risk of firms, either positively or negatively, as more information becomes available about them. From the perspective of investors, it is also important to know the re-rating of firms as a consequence of increased availability of information about them. It can be argued that given more information the re-rating of firms may result in some firms having an increase in the cost of capital as information asymmetries are reduced. Such negative re-rating would be beneficial for investors, as the right signal for capital allocation would be given. Chari and Henry (2004) observe that following liberalization, repricing of systematic risk of firms, which they find to be lower in investible firms and neutral for non-investible firms. There is also increasing evidence that openness to foreign portfolio investment enhances the governance of local corporations (see Doidge, 2003; Durnev, Li, Morck
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Daniel Makina, Associate Professor, University of South Africa,
[email protected] Minga Negash, Professor, University of the Witwatersrand,
[email protected]
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and Yeung, 2003). Bae, Bailey and Mao (2004) observe improvement in the information environment following liberalization. Whilst there have been extensive investigations of the impact of stock market liberalization using market level data, there has been few empirical studies that have used firm level data. Recent work at firm level by Patro and Wald (2004), Chari and Henry (2004), Patro (2004) and Christoffersen, Chung and Errunza (2004) support the predictions of theoretical international asset pricing models but at the same time show significantly different impact of stock market liberalization across firms. Our study complements these studies that use firm level data. However, unlike others that have taken a cross-country perspective relying on data from the IFC database, we focus on a single emerging market, South Africa, for comprehensiveness and we use reputable national and private databases as data sources. South Africa has undergone a number of changes during the past three decades some of which have been abrupt and some of a gradual nature. The debt standstill of 1985, the sanctions issue during the 1980s, political and financial liberalization in the 1990s all provide avenues for research on how firms have responded to these shocks. In particular, the effect of these shocks on financial sector development is bound to add to some insights on emerging market research. It is against this background that we examine the impact of liberalization on the cost of capital of a sample of firms listed on the Johannesburg Stock Exchange (JSE). We use structural break dates of market level financial time series for dating integration and benchmarking the pre-and postliberalization periods. Our contributions to emerging market research are three-fold. First, our findings show that stock market liberalization resulted in the majority of firms having a significant decline in the cost of capital. The observation that not all firms experienced a decline makes firm level analysis more insightful because market level results that show an overall decline in the cost of capital hide the fact the impact on cost of capital is not uniform across firms. Secondly, we show that a significant number of firms in our sample actually experienced an increase in the cost of capital indicating a negative rerating of firms following liberalization. We attribute this phenomenon to the increased availability of information that accompanies liberalization resulting in a re-rating of firms and upward repricing of risk. Thirdly, we show that the reduction in the cost of capital was independent of the sector to which a firm belongs. The rest of the paper is organized as follows. Section 2 outlines the background to the study and synthesizes the research problem. Section 3 describes the dating procedure used for dating the liberalization of the JSE. The terms stock market liberalization and market integration are used interchangeably in this paper. Section 4 briefly outlines the data and methodology used to test hypotheses. Section 5 discusses empirical results. Section 6 concludes. RELEVANT LITERATURE AND HYPOTHESES Theoretical or empirical literature has paid little attention to what drives financing patterns of the individual firm in emerging economies. One study by Singh (1995) provides one of the most notable empirical studies of corporate finance in developing countries during a period of both internal and external liberalization of stock markets. The study showed that firms rely on equity finance to fund corporate growth and that it becomes a more significant source of finance when the stock market is liberalized. Journal of Accounting and Finance Research, October 2005
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According to Singh this conclusion is theoretically unexpected because of the myriad of imperfections of emerging stock markets that include asymmetric information and poor governance. The more consistent expectation would be for firms to shun the stock market and rely more on retained earnings and debt finance. This would be in line with the traditional view - the “pecking order” theory of finance that characterize advanced country markets. The pecking order theory asserts that there is a strict hierarchy of firm preferences in financing decisions and stipulates that firms prefer internal to external finance, and when they do use external finance, they prefer debt finance, and only as a last resort equity finance (Myers, 1984). Apparent in this observation is that there is no linkage of the cost of capital to choice of finance. Preference of finance is attributed to behaviour of firms and this argument run contrary to Modigliani and Miller’s (1958) proposition of the irrelevance of capital structure as regards the cost of capital. An empirical study by Corbett and Jenkinson (1994) of developed countries, and a similar one by Wu and Negash (2002) of a developing country (South Africa) indicate a pecking order of financial sources. According to Singh and Hamid (1992), in an earlier study, the expectation is to observe developing and developed countries having a different pattern of finance. Developed country corporations could be reasonably expected to finance more of their growth through the intermediation of the market since they operate in the context of sophisticated markets (see also Myers and Majluf, 1984). On the contrary, the far less mature capital markets in developing countries should theoretically lead firms to utilize internal sources of finance for investment. Singh and Weisse (1998) argue that this should be so because of the informational and regulatory shortcomings of emerging markets as well as the fact that most firms in these markets do not have established market reputations and this should be reflected in their pricing processes being “noisy” and arbitrary. Surprisingly, some observations of Singh and Weisse (1998) and Singh (1995), namely, the stock market becoming a significant source of finance, are consistent with international asset pricing theory that suggests that stock market liberalization reduces the cost of equity capital of firms inducing them to re-evaluate previously rejected projects with negative NPVs leading to higher investment levels. The mere fact equity finance became a significant source of finance following liberalization should suggest that its cost would have become cheaper. Indeed, models of international asset pricing under capital market segmentation predict that as capital markets integrate, the cost of capital will decline as risk is globally diversified (Stulz, 1981; Errunza and Losq, 1985, 1989; Eun and Janakiramanan, 1986; and Stulz, 1999). Whilst empirical evidence supports these predictions, most studies had been done at market level. There are fewer studies that have examined firm level behaviour. Foerster and Karolyi (2000) and Errunza and Miller (2000) have examined the impact on the cost of capital for firms, which issue Depositary Receipts, but most of firms in their sample are from developed markets rather than emerging markets. Recent work at firm level in emerging markets by Christoffersen, Chung and Errunza (2004), Patro and Wald (2004), Chari and Henry (2004) and Patro (2004) support the predictions of theoretical international asset pricing models. The shortcoming of market level or index-based analysis is that it produces new listing and rebalancing biases in that firms are added and dropped; something that Finance - International
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complicates temporal comparison (Barber and Lyon, 1997). The market level International Finance Corporation (IFC) indices that are used may not represent the real portfolio holdings of investors and hence could under (over) estimate the impact depending on foreign demand for a security. The use of market-level indices may also not take into account firm level asymmetries embedded in investment decisions because different firms from a liberalized market may provide different diversification opportunities to the foreign investor. On the other hand, examining the same set of firms pre-liberalization and post-liberalization removes these biases from the analysis. Also, unlike market level analysis where there is need for controlling for confounding macroeconomic factors (e.g. see Bekaert and Harvey, 2000), firm level analysis makes these economy-wide control variables less relevant as an omnibus assumption can be made that all firms faced the same macroeconomic environment both during the preand post-liberalization periods. This paper further examines financial effects of stock market liberalization. In essence, it tests the prediction regarding the cost of capital using firm-level data of a single emerging market. Notwithstanding, the approach adopted is top-down. The analysis starts at market level and drills down to firm and sector level analysis. This approach is borne from an intuitive observation that a market level decline in the cost of capital following stock market liberalization may not necessarily be transmitted to all firms and sectors. Roll (1992) has suggested that industry factors are primary in explaining international market returns. On the other hand, Heston and Rouwenhorst (1994) and Griffin and Karolyi (1998) suggest that industry factors only explain a small fraction of country index returns. A firm level cross-section analysis by Patro and Wald (2004) find sector composition to have a small influence. Hence, evidence is inconclusive. We also examine the possibility of negative re-rating of firms following liberalization that may result in some having an increase in the cost of capital as result of such re-rating and upward repricing of risk. Intuition would suggest that closed economies give shelters to select (favoured) firms and insulate them from outside competition. So far empirical studies tend to focus on looking for positive effects in the sense of a decline in a firm’s cost of capital following liberalization. For instance, the recent firm level analysis by Chari and Henry (2004) stresses the repricing of systematic risk in the sense that it becomes lower in investible firms and remains neutral in non-investible firms. Studies tend to ignore the positive effect emanating from an increase in cost of capital of a firm following its re-rating as a result of the opening up of the market that exposes it to outside competition. To investors this is important because it indicates that market segmentation could have been giving wrong signals as regards the firm’s “correct” cost of capital. Indeed, recent research by Bae, Bailey and Mao (2004) shows that market liberalization generally improves the information environment in the country. This observation is significant because one barrier to investment in emerging markets is information asymmetry. In the international asset pricing models (IAPMs) of Stulz (1981), and Errunza and Losq (1985), the informational barrier is seen to render cross-border investments costly, or prohibit such investments in the limit. Also, from a survey of market experts and participants, Chuhan (1994) reports limited information as one of the major Journal of Accounting and Finance Research, October 2005
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impediments to investing in emerging markets. Therefore, liberalization should have an effect of reducing information asymmetries. Unlike most studies that rely on data from the Standard & Spoor’s IFC Emerging Market Data Base (EMDB), we use national and private databases as data sources. The reason is that the IFC EMDB may not be representative of all firms in an economy because IFC uses size, liquidity and industry as criteria in selecting stocks to include in a country index which results in the inclusion of the largest and the most actively traded stocks on the major exchange of each market. Such an approach could cloud analysis in markets (e.g. South Africa) with firms characterised by pyramid structures Therefore, the use of national databases would ensure that a large cross-section of firms in an economy is sampled. Empirical work proceeds to test the following two hypotheses:
Hypothesis 1: Stock market liberalization reduces the cost of capital of firms. Hypothesis 2: The impact of stock market liberalization on cost of capital is independent of the sector to which the firm belongs. However, hypothesis testing is preceded by first resolving the issue of dating stock market liberalization. Most studies on impact of stock market liberalization benchmark analysis around official liberalization dates. In this paper we utilize structural break dates in the manner suggested by Bekaert, Harvey and Lumsdaine (2002) and Chaudhuri and Wu (2003). Notably, it has been observed that impact becomes stronger if dates of liberalization are determined from structural breaks (Bekaert, Harvey and Lundblad, 2003). DATING THE LIBERALIZATION OF THE JSE The JSE is characteristically an emerging market possessing some features of barriers to investment as identified by Bekaert (1995), namely, legal barriers, indirect barriers and specific emerging market risks such as liquidity, political, economic policy, and currency risk. In prior empirical studies three dates have suggested to date the liberalization of the JSE. In the first instance, Brooks, Davidson and Faff (1997), using a family of ARCH and GARCH models to study the behaviour of volatility measures utilized February 2, 1990, the date the then South African President, FW de Klerk, unbanned the African National Congress (ANC), as benchmark date for analysis. The authors observed greater integration of JSE with the international market in the post-1990 period. The observation is consistent with empirical evidence by Bekaert and Harvey (1995) that observed a sharp increase in the market integration parameter in the late 1970s in the case of Zimbabwe that coincided with the optimism leading to independence officially achieved on April 18, 1980. It can be argued that the same could be inferred for South Africa. Political liberalization that started in 1990 leading to democratic elections in 1994 could have generated positive expectations that could have induced structural breaks in time series data of stock market variables related to the cost of capital. Secondly, in a cross-country study that included South Africa enquiring whether financial liberalization spurs growth, Bekaert, Harvey and Lundblad (2001) used the end Finance - International
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of the year 1992, by which time most economic sanctions were lifted for the country following political liberalization, for dating the liberalization the JSE. Thirdly, FuchsSchundeln and Funke (2001) whose cross-country study (in which South Africa was included) examined the financial and macroeconomic implications of stock market liberalizations, utilized March 1995, the official date when the JSE was liberalized, for benchmarking analysis. Defining the date of stock market liberalization as that on which there is a structural change in stock market financial time series data, Makina and Negash (2005) resolve the problem by testing for structural breaks around the three dates. They use the Chow test and the Broken Trend Stationary (BTS) model formalised from Perron (1989) to perform tests on stock market data (dividend yield, stock market liquidity and real stock price) on the three dates to determine the date(s) at which there was a significant structural break. From the time series of the aggregate dividend yield and stock market liquidity, they report two structural breaks -the first of which occurred in February 1990, and the second in December 1992 at respectively 90% and 95% confidence level. From time series of the real aggregate stock price one structural break that occurred in December 1992 is reported at 90% confidence level. Noteworthy is that the structural breaks occurred earlier than the JSE official liberalization date of March 1995 for which no structural break was reported. This suggested that political and economic policy risks were the more binding constraints than direct legal barriers and other indirect barriers in the case of South Africa. On the contrary Bekaert, Harvey, and Lumsdaine (2002) show majority of countries (excluding South Africa) having structural breaks taking place endogenously well after regulatory liberalization dates. The structural break dates are used as benchmarks for the liberalization event for testing firm level hypotheses. It is assumed that all firms also experience structural changes around these dates. Whilst this is assumption may be true for the majority of firms, especially for investible firms, it is acknowledged that there are possibilities that some firms experienced structural changes at different dates. Notwithstanding, the preliberalization period is taken as pre-February 1990 period, and the post-liberalization period as post-December 1992 period. The period February 1990 to December 1992 is considered a liberalization window, especially as regards political liberalization and the easing of economic sanctions. DATA AND METHODOLOGY As in Bekaert and Harvey (2000) and Errunza and Miller (2000), we use the dividend yield as our proxy for the cost of capital. It is a good proxy if we assume the growth rate of dividends (g) remains the same after the liberalization event in the constant Gordon Dividend Growth Model given by: k = D/P + g
[1]
Where k denotes the cost of capital and D/P denotes dividend yield under assumptions of stable earnings growth rate at or below the nominal growth rate of the economy, well-established dividend payout policy continuing in the future and stable leverage and beta. The results were however checked for robustness using the earnings yield as proxy for cost of capital. Journal of Accounting and Finance Research, October 2005
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Dividend yield data was obtained from the database of the South African Reserve Bank and McGregor BFA Database, a private database for JSE listed companies. Our sample of firms comprised 83 firms continuously listed on the JSE from 1987 or earlier right through to 1997. The objective was to have the same set of firms with a stable dividend policy that survived both the pre-and post-liberalization periods without changing identity and main business line in order to facilitate proper intertemporal comparison. The firms chosen represented the exchange’s main seven sectors classified according to the FTSE Global Classification System, viz., Resources, Basic Industries, General Industrials, Cyclical Consumer Goods, Non-Cyclical Consumer Goods, Cyclical Services and Financials. Broad sectors for which sector level dividend yield data were available were Resources, Financials, Commercial and Industrials as per South African Reserve Bank classification. Given the observations by Bekaert, Harvey and Lumsdaine (2002) and Lewellen (2004) that the dividend yield series are stationary, a t-test comparison of pre- and post-event date means of the dividend yield (proxy for cost of capital) under assumptions of equal variances is considered adequate to gauge the effects of liberalization [see Levine (2001) for similar treatment]. The pre-liberalization period and the post-liberalization are considered two independent periods that differ significantly from one another and hence amenable to a t-test for independent samples for testing the hypothesis that stock market liberalization leads to a reduction in the cost of capital. Our choice of the relevant length of periods for analysis of “before” and “after” liberalization is guided by the observation by Bekaert et al (2002a) who find that net capital flows to emerging markets increase rapidly after liberalization as investors rebalance their portfolios, but that they level out after 3 years [see Bacchetta and Wincoop (2000) for further evidence]. Accordingly, we therefore compare monthly dividend yield data 36 months before liberalization with monthly yield data 36 months after liberalization. Furthermore, we test the second hypothesis that the reduction in cost of capital is independent of the sector a firm belongs by utilizing the Chi-Square test for Independence, and check for robustness by performing t-test at broad sector level for which sector level dividend yield data are available.
EMPIRICAL RESULTS AND DISCUSSION
TESTING HYPOTHESIS 1: STOCK MARKET LIBERALIZATION REDUCES THE COST OF CAPITAL OF FIRMS
We first perform the t-test on market level data and proceed to firm level analysis. The null hypothesis (H0) and alternative hypothesis (H1) are set as follows using the dividend yield as proxy for cost of capital: H0: DY1 = DY2 H1: DY1 > DY2 or DY1 < DY2 Where: DY1 DY2 DY1 DY1
= = >
