National Culture and Profit Reinvestment: Evidence from Small and Medium‐Sized Enterprises

• Author: Liang Shao,Sadok El Ghoul,Omrane Guedhami,Chuck Kwok
• Published date: 01 March 2016
• DOI: http://doi.org/10.1111/fima.12107
• Date: 01 March 2016

National Culture and Profit

Reinvestment: Evidence from Small

and Medium-Sized Enterprises

Sadok El Ghoul, Omrane Guedhami, Chuck Kwok, and Liang Shao∗

We examine the role of national culture—an important informal institution—in the profit rein-

vestment decisions of small firms in emerging markets. Prior economic development literature

focuses on formal institutions as determinants of growth. However, in emerging markets where

formal institutions are less developed, informal institutions should have more of a direct versus

indirect impact throughformal institutions. We find that Schwartz’s cultural dimensions of Embed-

dedness and Hierarchynegatively affect profit reinvestment, and that access to external financing

(strength of property rights) is more important for reinvestment decisions in countries with low

(high) Embeddedness and Hierarchy.

What factors contribute to economic development? Prior research points to two formal insti-

tutions: strength of property rights (e.g., Mauro, 1995; Svensson, 1998; Claessens and Laeven,

2003) and access to external financing (e.g., Levine, 1997; Rajan and Zingales, 1998; Levine,

Loayza, and Beck, 2000). Country-level data cannot shed light on which of these institutions

is more important for economic growth because they are highly correlated. Recent research

therefore relies on micro data to disentangle the effects of property rights and external finance,

examining their relative importance in explaining firms’ profit reinvestment decisions. Johnson,

McMillan, and Woodruff (2002), for instance, demonstrate that weak property rights are the

central impediment to profit reinvestment in five postcommunist countries (Poland, Slovakia,

Romania, Russia, and Ukraine). In contrast, Cull and Xu (2005) find for a sample of fir ms from

China that access to external financing is an equally important predictor of prof it reinvestment,

suggesting that the importance of market-supporting (financial) institutions depends on the level

of development of a country’s economy (McMillan and Woodruff, 2002).1Extending the above

line of research, in this paper, weexamine the relation between an important informal institution—

national culture—and profit reinvestment by small firms in emerging markets and we investigate

whether culture affects the relative importance of formal institutions for profit reinvestment

decisions.

We thank an anonymous reviewer, Najah Attig, Narjess Boubakri, Raghavendra Rau (Editor), and Xiaolan Zheng

for constructive comments. We appreciate generous financial support from Canada’s Social Sciences and Humanities

Research Council.

∗Sadok El Ghoul is an Associate Professor at the University of Alberta in Edmonton, Canada. Omrane Guedhami is an

Associate Professor at the Darla MooreSchool of Business at the University of South Carolina in Columbia, SC. Chuck

Kwok is the Distinguished Business PartnershipFoundation Fellow and Professorof International Business at the Darla

Moore School of Business at the University of South Carolina in Columbia, SC. Liang Shao is an Assistant Professor of

Finance at the Hong Kong Baptist University,Hong Kong.

1These findings on the role of property rights and external finance in prof it reinvestmentare echoed in Chakravarty and

Xiang (2011) and Ayyagari, Demirg¨

uc¸-Kunt, and Maksimovic (2010, 2011).

Financial Management •Spring 2016 •pages 37 – 65

38 Financial Management rSpring 2016

Weare interested in the role of national culture for economic growth in emerging economies for

two reasons. First, in such economies where formal institutions are weaker, informal institutions

such as national culture should matter more. Hence, we should be more likely to observe a

direct effect of informal institutions, as opposed to an indirect effect through formal institutions.

Hofstede (2001) shows that national culture and economic development are correlated. However,

the literature has yet to identify a clear channel through which informal institutions affect the

economy. A direct association between culture and profit reinvestment may provide one answer.

Second, because culture is located at the most basic level in a stratified system of institutions

(Williamson, 2000), and formal institutions must be compatible with culture in order to be

effective (Licht, Goldschmidt, and Schwartz, 2005), the effectiveness of efforts to increase the

level of economic development (e.g., by facilitating profit reinvestment) is likely to depend on a

country’s cultural profile.

To proxy for culture, we focus on two cultural dimensions from Schwartz’s (1994) widely

accepted framework: Embeddedness, which captures cultural emphasis on conformity and the

status quo, and Hierarchy,which captures cultural acceptance of an unequal distribution of power.

These dimensions may affect reinvestmentindirectly, through their correlations with formal insti-

tutions such as economic development, political rights, and economic freedom (Schwartz, 2006),

or directly, through their effect on the motivation to invest. To the extent that our sample focuses

on emerging markets with similarly weak formal institutions and a large number of small firms

for which investment policies are largely determined by managers’ individual investment moti-

vations, culture is more likely to exert a direct effect than an indirect effect on reinvestment. We

obtain profit reinvestment and other firm-level information from the 2002 to 2005 standardized

Enterprise Surveys conducted by the World Bank. Using this information, weconstr uct a sample

of 5,752 small firms from 22 emerging economies.

To control for indirect channels of the effect of culture and distinguish firm- versus country-

level effects, we employ a hierarchical linear model (HLM) following Li et al. (2013). We

find that Embeddedness and Hierarchy are negatively correlated with profit reinvestment,

after controlling for firm characteristics, other informal institutions such as trust and reli-

gion, and formal institutions such as economic development, economic freedom, political

rights, transition economy, legal protection, and financial market development. Furthermore,

for the most part, the formal institutions considered do not affect profit reinvestment signifi-

cantly, which suggests that the documented effect of culture is mainly due to the direct link

and that culture matters for firms in emerging markets characterized by a weak institutional

environment.

To mitigate the endogeneity concern that our results may be driven by a failure to control for

institutions that determine both culture and profit reinvestment, we instrument Embeddedness

and Hierarchy with a country’s latitude as well as its religious composition and fractionalization.

The effect of culture on profit reinvestment persists in the two-stage instrumental variables

regression. We also test whether alternative explanations could be behind a lower motivation

to invest. In particular, firms in high-Embeddedness and -Hierarchy countries may reinvest less

profit because they 1) rely more on external financing such as debt, 2) are subject to greater

constraints on investment, 3) have more internal funds, 4) face less competition, or 5) have

different corporate governance structures. Our analyses do not lend support to these alternative

explanations.

In additional analyses, we investigatewhether the two formal institutions previously identified

as determinants of profit reinvestment—namely, access to external financing and strength of

property rights—affect profit reinvestment differently across different cultures. We find that ac-

cess to external financing (strength of property rights) is more important for prof it reinvestment