POLICY RESEARCH WORKING PAPER 2033

# Su mni ary findings

The East Asian financial crisis has been attributed in part to the corporate diversification associated with the misallocation of capital investment toward less profitable and more risky business segments. Much anecdotal evidence to support this view has surfaced since the crisis but there was little discussion of it before the crisis. Quite the contrary: The rapid expansion of East Asian firms by entering new business segments was viewed as contribuiting to the East Asian miracle.

Claessens, Djankov, Fan, and Lang examine the efficiency of investment by diversified corporations in nine East Asian countries, using unique panel data from more than 10,000 corporations for the pre-crisis period, 1991-96. They:

**-** Document the degree of diversification in the corporate sector in Hong Kong, Indonesia, Japan, the Republic of Korea, Malaysia, the Philippines, Singapore, Taiwan (China), and Thailand, countries that have achieved enviable rates of economic growth over the past three decades.

* Distinguish between vertical and complementary diversification and study the differences across nine countries.

Investigate whether diversification in East Asia has hurt economic efficiency.

Their study tests the learning-by-doing and misallocation-of-capital hypotheses related to the types and degrees of diversification in East Asiar. countries. Firms in Indonesia, Korea, Taiwan, and Thailand appear to have suffered significant negative effects of vertical integration on short-term performance; the same countries gained significant short-term benefits from complementary expansion. The results suggest that the misallocation-of-capital hypothesis is appropriate for Korea and Malaysia; the learning-by-doing hypothesis for Indonesia, Taiwan, and Thailand.

Firms in more developed countries succeed in vertically integrating and improve both short-term profitability and market valuation. Firms in more developed countries are ultimately more likely to benefit from such diversification (learn faster, to improve their performance). And diversification by firms in less developed countries is subject to more misallocation of capital.

- This paper -a product of the Economic Policy Unit, Finance, Private Sector, and Infrastructure Network is part of a larger effort in the department to. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Rose Vo, room MC10-628, telephone 202-473-3722, fax 202-522-2031, Internet address ivol@worldbank.org. The authors may be contacted at cclaessens@worldbank.org or sdjankov@worldbank.org. December 1998. (30 pages).

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