Monthly Archives: May 2012

Weak governance and a vicious cycle

It is a very simple and straightforward phenomenon: weak governance increases the cost of equity. But its feedback loop can create a vicious cycle that gradually increases the systematic risk of the financial system; and the process to unwind it could be long and painful. There are three parts that feed into each to create such cycle.

The first part, weak governance increases the required return of holding equity. Suppose a company needs to raise capital for new projects. Because of weak corporate governance, e.g. disclosed accounting information being insufficient or easily manipulated by management, investors find it difficult to monitor the company and its profit generation. In such case, investors may prefer to be the creditor rather than the shareholder of the company. That is because shareholders only claim the residual value of the company; under weak governance, a bulk of the company’s value-added may have been transferred into managers’ pockets, or officials’ pockets as the company’s relationship with government may be murky at best. In contrast, while having a capped upside, the creditor has senior claims to cash flow. After all, in a world of high risk aversion, cash is king. Due to investors’ preference to debt/loan financing over equity financing, cost/required return of equity increases.

The second part, which is more worrying, is that such higher required return may not materialize into higher return on equity, but only higher volatility. Such effect is particularly pertinent to pro-cyclical and high-gearing companies. Let me explain why. Weak governance should have increased the default/bankruptcy risk of the company. However, in a country without fully-fledged bankruptcy law, default/bankruptcy is not an option for a company to restructure itself, fire the incompetent managers and re-align the company’s interest with its management. Worse still, bankruptcy may be seen as an insult – an additional reputational cost on top of the financial cost. Such reputational cost may not only ties to senior managers, but also some “stakeholders”, like local government officials if they regard the health of the company as a yardstick of their own policymaking. Such phenomenon is not uncommon if the company contributes a large amount of local tax returns and employs a large number of local labor force. Therefore, during the economic recession when the perceived default risk increases, the local government has large incentive to use its fiscal power to help the company refinance its debt, e.g. by asking local banks to roll-over debt without recognizing the increased credit risk. Such action is similar to bailout, but worse than bailout, because managers haven’t been made redundant and any inefficient part of the operation has not been removed. In other word, economic value has not been generated in such refinancing event; it is merely a shift of credit cost from the company (and the management) to the banks and local government. For shareholders of the company, although they do not face bankruptcy, their future equity return is definitely lower because they are forced to take on more debt, pay out more cash as interest and principal to creditors, and equity return becomes more unpredictable due to higher gearing. In short, the company is sliding towards becoming a zombie – inefficiently generating cash flow, just to cover interest payment.

The third part is about how such “zombie” companies could translate into systematic mispricing in credit, systematic risks in the banks and corporate bond market, and eventually a vicious cycle. If the creditors still get paid during recession, that definitely increases the attractiveness of investing in bonds/loans which mainly focus on downside risks. At least, one does not need to worry about default and recovery rate. It pulls down the required return of debt financing and further allures the company to raise debt instead of equity to finance new projects. Therefore, as the company is gradually taking on more debt, ironically it is more motivated to raise debt rather than to raise equity, to meet investors’ preference. Note that this could become systematic as it serves the incentive of both the companies and investors! When everyone does it, the credit-driven vicious cycle is formed. And debt is accumulating.

Above are the three parts of how weak governance, among other things, can drive a formation of a vicious cycle. In what way could it get reversed? When does it go bust? I guess, it will first reach a point of “too big to fail”, and then it will bust as it comes across a point of “too big, and hence has to fail”. The reflexion point is the point of reversing confidence. As the debt goes bigger and bigger, the system increasingly relies on people’s belief that the status quo would continue, although the ground looks increasingly shaky. Of course, the bigger the debt, the bigger the contagion risk when it collapses. That is the power of systematic risk.

How to unwind the cycle before it goes bust? Apparently some fundamental measure has to been taken, such as the strengthening of corporate governance. However, such measure takes a long time to take effect – that’s why the unwinding process can be really long and painful.

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