Political Connections and Allocative Distortions

• Date: 01 April 2019
• Author: DAVID SCHOENHERR
• Published date: 01 April 2019
• DOI: http://doi.org/10.1111/jofi.12751

THE JOURNAL OF FINANCE •VOL. LXXIV, NO. 2 •APRIL 2019

Political Connections and Allocative Distortions

DAVID SCHOENHERR∗

ABSTRACT

Exploiting a unique institutional setting in Korea, this paper documents that politi-

cians can increase the amount of government resources allocated through their social

networks to the benefit of private firms connected to these networks. After winning

the election, the new president appoints members of his networks as CEOs of state-

owned firms that act as intermediaries in allocating government contracts to private

firms. In turn, these state firms allocate significantly more procurement contracts

to private firms with a CEO from the same network. Contracts allocated to con-

nected private firms are executed systematically worse and exhibit more frequent cost

increases through renegotiations.

AGROWING LITERATURE DOCUMENTS A positive relationship between political

connections and firm value for a large set of countries,1providing evidence

of different benefits that accrue to politically connected firms.2While this

∗David Schoenherr is at Princeton University.I am deeply grateful to my advisor Vikrant Vig for

his generous and invaluable guidance. I thank Pat Akey, Taylor Begley, Joao Cocco, James Dow,

Alex Edmans, Julian Franks, Mireia Gine, Francisco Gomes, John Griffin, Rainer Haselmann,

Samuli Kn¨

upfer, Ralph Koijen, Ilyana Kuziemko, Megan Lawrence, Mina Lee, Stefan Lewellen,

Jean-Marie Meier, Atif Mian, Todd Mitton, Kasper Nielsen, Gen-Ichiro Okamoto, Elias Papaioan-

nou, Megha Patnaik, Tarun Ramadorai, Ville Rantala, Amit Seru (the Editor), Henri Servaes,

Rui Silva, Janis Skrastins, Jan Starmans, Ahmed Tahoun, an anonymous Assistant Editor and

two anonymous referees; seminar participants at Boston College, Duke University,the Federal Re-

serve Board, the Hong Kong University of Science and Technology, IESE Business School, INSEAD,

London Business School, Princeton University, Stanford University, UC Berkeley, the University

of Chicago, the University of Colorado Boulder, the University of Pennsylvania, Vienna Univer-

sity, and Washington University at St. Louis; and conference participants at the 2018 American

Finance Association, the 27th Australasian Finance and Banking Conference and PhD Forum,

the 2015 European Economic Association Meeting, the 2015 European Finance Association Doc-

toral Tutorial,the 2017 Financial Intermediation Research Society Meeting, the 14th Transatlantic

Doctoral Conference, and the 2016 Western Finance Association Meeting for their many helpful

comments and suggestions. I declare that I have not received significant financial support related

to the research described in this paper.

1See Roberts (1990), Fisman (2001), Johnson and Mitton (2003), Jayachandran (2006), Faccio

(2006), Ferguson and Voth (2008), Bunkanawanicha and Wiwattanakantang (2009), Faccio and

Parsley (2009), Goldman, Rocholl, and So (2009), Cooper, Gulen, and Ovtchinnikov (2010), Amore

and Bennedsen (2013), Akey (2015), Acemoglu et al. (2016), and Acemoglu, Hassan, and Tahoun

(2018).

2In particular,the literature shows that politically connected firms have better access to finance

(Khwaja and Mian (2005), Leuz and Oberholzer-Gee (2006), Claessens, Feijen, and Laeven (2008),

Li et al. (2008)), are more likely to receive government funds, bail-outs, and contracts (Faccio,

DOI: 10.1111/jofi.12751

543

544 The Journal of Finance R

relationship has been widely documented, however, evidence on the under-

lying mechanisms is scarce. On the one hand, public officers who control

the allocation of government resources may abuse their power and trans-

fer rents to connected firms at the expense of allocative efficiency. On the

other hand, to the extent that connections help mitigate frictions such as

information asymmetries or moral hazard problems, public officers may be

able to better allocate resources through connected firms. Given the large

amount of resources allocated by governments,3a thorough understanding

of the underlying mechanisms is important, as alternative mechanisms have

different implications for economic efficiency and in turn different policy

implications.

In this paper, I exploit a unique institutional setting and detailed microlevel

data on public procurement contract allocation in Korea to explore an impor-

tant mechanism through which firms benefit from political connections and

its implications for allocative efficiency. In Korea, the president has the au-

thority to appoint the CEOs of state-owned firms. These state firms play an

important role as intermediaries in allocating public procurement contracts to

private firms. Following his election in 2007, the new president, Lee Myung

Bak, appointed a large number of people from two of his networks—alumni

from Korea University Business School (KU network) and former executives

of Hyundai Engineering & Construction (HEC network), the firm he worked

for before going into politics, as CEOs in many state firms. Private firms with

a CEO from one of the president’s networks thus suddenly became connected

to a large number of state firms with a newly appointed CEO from the same

network.

Examining changes in public procurement contract allocation around the

election, I find that private firms connected to the new president’s networks

experience a significant increase in their annual public procurement contract

volume, equal to 3% of the firms’ assets, after the election.4Cross-sectional vari-

ation in connectedness to different state firms allows me to compare changes in

contract allocation to the same private firm at a given point in time (firm-time

fixed effects). I find that the increase in contract volume is driven by those state

firms in which the president appointed a CEO from the same network. This

suggests that private firms benefit from the appointment of state firm CEOs

from the same network.

Masulis, and McConnell (2006), Duchin and Sosyura (2012), Cingano and Pinotti (2013), Goldman,

Rocholl, and So (2013), Tahoun (2014), Baltrunaite (2018), Brogaard, Denes, and Duchin (2017)),

and avoid compliance with regulations (Fisman and Wang (2015)).

3Public procurement contracts alone account for 10% to 20% of GDP in developed countries

(OECD (2015)).

4Private firms connected to Lee Myung Bak’s networks experience 2.21 (4.45) percentage point

higher returns than nonconnected firms the day (week) after his nomination as his party’s presi-

dential candidate in a close election. This amounts to 8.51% of connected firms’ combined market

value, and 0.63% of total KOSPI (Korea’s main stock market index) market capitalization. The

additional contracts allocated to connected private firms explain about 20% of the increase in

connected firms’ market value.

Political Connections and Allocative Distortions 545

While private firms connected to the president’s networks benefit from the

appointment of connected state firm CEOs, higher allocation of government

contracts from state firms to private firms with a CEO from the same net-

work is not limited to the new president’s networks. Exploiting information on

CEOs’ educational background, I find that private firms generally experience

an increase in contract volume from state firms that they become connected to

through their CEO’s alumni network. Additionally, private firms with a CEO

from the KU network do not experience an increase in contract volume from

state firms in which the new president appointed a CEO from the KU network

if that state firm already had a CEO from the KU network before the election.

Together these results suggest that private firms receive more government

contracts due to their CEO’s connections to state firm CEOs, regardless of con-

nections to the president. The president’s role in benefiting firms connected to

his networks is to increase the number of state firm CEOs from his networks.

These results document an important mechanism through which politicians

benefit connected firms: the authority to appoint people to important positions

allows politicians to increase the amount of government resources allocated

through their networks.

Next, I examine how connections between state firm and private firm CEOs

affect the efficiency of contract allocation. An increase in procurement con-

tracts allocated to connected firms would be consistent with a benign role of

connections in mitigating frictions, but also a malign role of connections in

distorting resource allocation. For example, state firm CEOs may have better

information about people from their network, which would allow them to bet-

ter allocate contracts within the network (Cohen, Frazzini, and Malloy (2008),

Conley and Udry (2010)), or may be better able to monitor connected firms

and resolve problems that occur during contract execution through a social

collateral channel (Kandori (1992), Guiso, Sapienza, and Zingales (2004), Am-

brus, M¨

obius, and Szeidl (2014)). Alternatively, state firm CEOs may extend

preferential treatment to connected firms, allocating contracts to these firms

even if they are not able to execute these contracts effectively (Banerjee and

Munshi (2004), Hwang and Kim (2009), Haselmann, Schoenherr, and Vig

(2018)). Understanding which of these forces dominates is important, as they

have different implications for the optimality of network connections between

representatives of government entities and private firms, and hence lead to

different policy implications.

Comparing the execution of contracts allocated to the same private firm by

connected and nonconnected state firms allows me to assess how connections

affect allocative efficiency. Data on contract amendments, including informa-

tion on contract performance (delays, financial problems, construction mis-

takes, etc.), are available for all construction contracts. After the election, the

performance of contracts allocated to connected private firms deteriorates sig-

nificantly relative to the performance of contracts allocated to nonconnected

firms. Contracts allocated to connected firms are about 10 percentage points

more likely to exhibit adverse outcomes. In addition, construction costs in-

crease about 5 percentage points more often for contracts allocated to connected