Finding the right corporate framework
Yesterday, this column flagged that the SECP did not consult economists while framing the latest corporate governance rules for unlisted companies. In the past too, sources say, that the SECP has rarely held consultative sessions with economists while drafting different set of corporate laws, rules, regulations and frameworks.
Today’s piece is to bring home the point that since market economies come in different shapes and forms, corporate laws and corporate governance rules should be accordingly tailor-made, instead of merely learning from the region or from the Anglo-Saxon West or only relying on consultative sessions with accountants, businessmen and lawyers. Indeed, economists matter too.
At the risk of simplicity, market economies can be classified in two broad categories: liberal market economies (LMEs), and coordinated market economies (CMEs). The former includes the likes of UK, US, Canada and Australia. The latter includes the likes of Germany, Italy, France, Belgium and so forth.
In LMEs, firms coordinate their activities primarily through competitive market arrangements. Market relationships in LMEs are marked by arm’s-length exchange of goods or services in the context of competition and “formal contracting”. This works in response to price signals, and the actors adjust their willingness to supply and demand goods or services, often on the basis of the marginal calculations stressed by neoclassical economics.
In contrast, firms in CMEs heavily depend on non-market relationships to coordinate with other actors and to build their core competencies. These non-market modes of coordination are generally based on “relational contracting” (as against formal contracting), network monitoring based on the exchange of private information inside networks (as against price signals), and more reliance on collaborative, as opposed to competitive relationships to build the competencies of the firm.
Firms in LMEs are mostly engaged in business sectors that thrive on “radical innovation”, which implies “substantial shifts” in product lines, the development of entirely new goods, or major changes to production. On the flipside, firms in CMEs are relatively more involved in sectors that are marked by “incremental innovation” that implies continuous but small scale or piecemeal improvements to existing product lines and production processes.
While industries often go through a cycle of radical innovation to incremental innovation over long periods, the distinction between radical and incremental innovation is that the former has a significant impact on the market and the firms operating in that market, whereas the latter concerns gradual improvements in existing product, process, etc.
Radical innovation industries include the likes of mobile technology, bio technology, power & energy, advertising, airlines and corporate finance. Incremental innovation industries include the likes of engines, consumer goods, consumer durables, and machine tools.
Two other main differences between the LMEs and CMEs are the financing (or ownership structure), and labour market relations.
Firms in LMEs have a diffused ownership or financing structure where shareholders take a portfolio approach to investment and are more interested in maximizing profitability and shareholder value. In a mirror image, firms in CMEs have concentrated ownership or financing structure since they pursue strategic business interests. Even banks in CMEs tend to view their shareholdings as a mechanism to safeguard their loans and build business relationships with companies rather than as a direct source of income. (See Table 1 for example)
Similarly, in LMEs labour markets have few restrictions on layoffs and high rates of labour mobility mean that companies interested in developing an entirely new product line can hire personnel with the requisite expertise, knowing they can axe them if the project proves unprofitable. A flexible labour market nudges employees to focus more on their personal career rather than the firm’s success and on the development of general skills rather than the industry or company-specific skills conducive to incremental innovation. The institutional mechanism for labour and labour behaviour is quite the opposite in CMEs that are characterized by strong worker representation and consensus decision-making.
Lastly, as a logical consequence of these differences, LMEs follow a ‘shareholder’ model of corporate governance in which the maximization of shareholder value is the primary goal of the firm and only shareholders enjoy strong formalized links with top management. CMEs, on the other hand, follow a ‘stakeholder’ model of corporate governance where different stakeholders (including owners, employees, suppliers and customers, and the communities companies are located in) enjoy a voice in the firm and whose interests are to be balanced against each other in management decision making (See Table 2).
Contextualizing Pakistan
Given Pakistan’s chequered economic history and lack of relevant literature, it is difficult to classify the country’s economy in either the LMEs or CMEs.
Pakistan’s labour market regulations are not as much entrenched as is the case with CMEs. However, the financing (or ownership) structure in listed and unlisted firms across various sectors in Pakistan seems to be characteristic of a CME with more firms having strategic business stakes than a typical portfolio-approach holding structure. When the last time a Pakistani firm raised monies from the stock market or venture capital for Greenfield projects?
Likewise, while Pakistan does not boast either of the box standard radical or incremental innovations that come to mind in the LME/CME context described above, the industries that contribute the most to GDP or to exports are those where incremental innovation is observed. Think: fan, textile, leather, cutlery, sports, food & beverages, paper, surgical goods, jewellery etc. These industries are those where Pakistan has relative comparative advantage and have been established several decades ago.
Of course Pakistan has commercialised radical innovation industries (such as telecom, advertising, banking, and power) ala LMEs. But they are late technology adopters, than innovators. And even in these sectors, the ownership structure is much concentrated than diffused ala the LME model.
This column will not attempt to classify Pakistan as either an LME or a CME; nor will it try to suggest the direction Pakistan should take. But the only emphasis of today’s piece is that those operating in corporate law space in Pakistan should consult more with economists (and other members of academia whose research interests lie at firm or sector level), conduct relevant economic/sectoral studies, before drafting appropriate corporate laws, rules, guidelines and frameworks. Hopefully, this column would kick start the much needed discourse on the subject.
Note: This piece relies heavily on the findings of the book called ‘Varieties of Capitalism: The Institutional Foundations of Comparative Advantage’ by Peter A. Hall and David Soskice.
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Table 1: Percentage of Total Shares in Circulation Held by
Different Sectors in Germany and the UK, End of 1995
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UK Germany
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Households 29.6 14.6
Enterprises 4.1 42.1
Public sector 0.2 4.3
Banks 2.3 10.3
Insurance enterprises and pension funds 39.7 12.4
Investment funds and other financial institutions 10.4 7.6
Rest of world 13.7 8.7
Total 100 100
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Source: Peter Hall and David Soskice, Varieties of Capitalism:
The Institutional Foundations of Comparative Advantage, 2001
