metadata: authors: 0: author: Allayannis,George
1: author: Brown,Gregory W.
2: author: Klapper,Leora
count: World
docna: 0: docna: Legal effectiveness and external capital :
            the role of foreign debt
docty: Policy Research Working Paper
subtopic: Financial Economics,Finance and Development,Regulatory Regimes,Judicial System Reform,Legislation,Social Policy,Legal Products,Legal Reform,Capital Markets and Capital Flows,Capital Flows,International Trade and Trade Rules
teratopic: Macroeconomics and Economic Growth,Social Development,Law and Development,Governance,Public Sector Development,Finance and Financial Sector Development,International Economics and Trade
abstracts: cdata!: Previous research has documented weak,
            and sometimes conflicting, effects of legal quality on
            measures of firm debt. Using WorldScope data for 1,689
            firms, as well as more detailed proprietary data for 315
            firms across nine East Asian countries, the authors find
            that access to foreign financing appears to loosen borrowing
            constraints associated with poor legal systems. This helps
            resolve inconsistencies in prior findings and explains how
            legal protection is important for borrowing by firms. In
            particular, they find that legal effectiveness is important
            for determining the amount, maturity, and currency
            denomination of debt. The authors discuss several mechanisms
            by which firms can avoid the costs of poor legal systems
            with foreign borrowing. The paper contributes to the policy
            debate surrounding the importance of creditor rights for
            domestic lending.
repnme: repnme: Legal effectiveness and external capital :
            the role of foreign debt
display_title: Legal effectiveness and external
            capital : the role of foreign debt
listing_relative_url: /research/2005/03/5635636/legal-effectiveness-external-capital-role-foreign-debt
topicv3: Justice m1326106 840,Common Law m1326145 2071,Trade m1326924 698,Capital Markets m1326967 332,Finance and Growth m1327404 1081
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Macroeconomics and Economic Growth,Social Development,Law and Development,Governance,Public Sector Development,Finance and Financial Sector Development,International Economics and Trade
no_of_pages: 31
author_keys: 0: author_key: 639581
1: author_key: 911776
2: author_key: 390572
model_extractions: # **WPS3530**

## **LEGAL EFFECTIVENESS AND EXTERNAL CAPITAL: THE ROLE OF FOREIGN DEBT**

**George Allayannis** Darden School of Business University of Virginia PO Box 6550 Charlottesville, VA 22906 (434) 924-3434 <u>allayannisy@darden.virginia.edu</u>

**Gregory W. Brown** Kenan-Flagler Business School The University of North Carolina at Chapel Hill CB 3490, McColl Building Chapel Hill, NC 27599-3490 (919) 962-9250 <u>gregwbrown@unc.edu</u>

**Leora F. Klapper** Development Research Group The World Bank 1818 H Street, NW Washington, DC 20433 (202) 473-8738 <u>lklapper@worldbank.org</u>

## World Bank Policy Research Working Paper 3530, March 2005

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Policy Research Working Papers are available online at http://econ.worldbank.org._ We would like to thank Jack Glen, Patrick Honohan, Willliam Howarth, Vincent Palizatto, and Richard Roulier for their comments. This paper evolved from seminar discussions at Cornell University, Rice University, Georgetown University, The Darden School, The University of North Carolina at Chapel Hill, the 6<sup>th</sup> Georgia Tech International Finance Conference, the EFMA 2000 in Athens, the 11<sup>th</sup> Annual Financial Economics and Accounting Conference (Michigan) and the World Bank.
**LEGAL EFFECTIVENESS AND EXTERNAL CAPITAL: THE ROLE OF FOREIGN DEBT**

# **Abstract**

Previous research has documented weak, and sometimes conflicting, effects of legal quality on measures of firm debt. Using WorldScope data for 1,689 firms as well as more detailed proprietary data for 315 firms across nine East Asian countries, we find that access to foreign financing appears to loosen borrowing constraints associated with poor legal systems. This helps resolve inconsistencies in prior findings as well as explains how legal protection is important for debt use. In particular, we find that the legal effectiveness is important for determining the amount, the maturity, and the currency denomination of debt. We discuss several mechanisms by which firms can avoid the costs of poor legal systems with foreign borrowing. Finally, this paper contributes to the policy debate surrounding the importance of creditor rights for domestic lending.

2
# **I.   Introduction**

Recent research in law and finance has examined the legal determinants of external finance. LaPorta et al. (1997) find that legal rules and origin are important in determining the size of a country’s capital markets, especially its equity market. However, the role of legal factors in determining the size of debt markets is less clear. Using firm-level data LaPorta et al. find that the similarity of the ratio of _total debt to sales_ across countries of different legal origins is “... remarkable, and suggests ... a potentially important conclusion: large publicly traded firms get external debt finance in almost all countries, regardless of legal rules” (p. 1148). They conjecture that state intervention in the banking system may be the reason for the similarities.

Other research has examined legal determinants of firms’ capital structure decisions. For example, Demirguc-Kunt and Maksimovic (1999) study _debt-to-capital_ ratios for publicly traded firms in 30 countries and find “that reliance on long-term debt by large firms is clearly higher in countries with an effective legal system” (p. 325), but they also find “no evidence that the index of creditor rights helps predict either short-term or long-term leverage or debt maturity” (p. 329).<sup>1</sup> In addition, Demirguc-Kunt and Maksimovic find that in countries without the right of secured creditors to be paid first in bankruptcy, firms use relatively _more_ short-term debt—evidence consistent with the monitoring hypothesis of Diamond (1991). Similarly, Giannetti (2003) finds that firms in countries with stronger creditor rights have higher long-term debt. Recent work by Fan, Titman, and Twite (2003) examines leverage and maturity across 47 countries finding that a common law system is unrelated to leverage, but that weak legal system integrity, as measured by the corruption level, is associated with high leverage and more short-term debt. In sum, while there seems to be some evidence positively linking _long-term_ debt and legal effectiveness, the role of legal factors in determining the size of total corporate debt is complex and still not fully understood.

> 1 Specifically, they find that creditor rights are unimportant after controlling for legal origins and legal enforcement.

1
In this paper we explain some of the above findings by examining the role of foreign currency (FC) denominated debt as a source of external capital. We argue, and find confirming evidence, that FC debt is an important _missing_ piece of the puzzle. To the best of our knowledge, our analysis is the first to thoroughly examine the relation between foreign currency debt and legal effectiveness. We hypothesize that large publicly traded firms usually have access to FC debt, irrespective of the legal environment of the home country. This is because foreign loans often are structured to reduce the reliance on the local legal system (e.g., foreign jurisdictions apply, collateral is off-shore, guarantors’ assets are off-shore, etc.). Access to this market loosens borrowing constraints associated with poor legal systems so that the total debt of firms in these countries is comparable to that of firms in the best legal environments.<sup>2</sup> This also has implications for the maturity structure of debt since, consistent with the findings of DemirgucKunt and Maksimovic (1999) and Fan, Titman, and Twite (2003), local lenders in poor legal environments (the primary source of capital for smaller firms) prefer short-term loans. Consequently, legal factors are important for determining several aspects of debt, including the amount, the maturity, and the currency denomination of debt, but the importance of legal factors is obscured unless access to foreign currency debt markets is explicitly considered.<sup>3</sup> To test our hypotheses we examine the capital structure of over 1,600 firms in nine East Asian countries. We combine publicly available data from the WorldScope database with a proprietary database describing the currency denomination of debt. Although our sample of

> 2 A similar argument in spirit is made in Faulkender and Petersen (2003) regarding US firms, in which access to public bond market allows US firms to increase their debt level above that of firms without access to public bond markets. In our case, access to FC debt allows firms from poor legal systems to have higher debt than they otherwise would without access to FC debt.

3 Esty (2003) examines financing of greenfield project companies across 61 countries and finds that foreign banks provide a greater share of total funds in countries with strong creditor rights and strong legal enforcement. However, a greenfield project company from a country with low creditor rights protections differs from a typical foreign company in the same country in the way it seeks foreign funding. Most of these financing contracts are governed by UK or New York law, however, most of the operating contracts and virtually all of the enforcement of financial claims (e.g., seizure of collateral upon default) depends on the legal system in the country where the project is located. In contrast, as we describe in detail in the next 2
countries is relatively small, it spans the range of legal origins and qualities well, and as we show, it provides an even stronger characterization of the debt “puzzle” than samples with more countries. In particular, our sample exhibits a significant positive relation between an index of legal effectiveness (the “legality” measure of Berkowitz, Pistor, and Richard, 2003) and external equity, as well as a strong _negative_ relation between legality and debt. Advantages of using the legality measure over legal origin are that it is more comprehensive and it explicitly incorporates measures of the risks of expropriation and contract repudiation.

To examine our hypothesis that access to FC debt is critical in the association between corporate borrowing and legal effectiveness, we split our sample into two groups, firms with foreign debt and those without foreign currency debt.<sup>4</sup> First, we find that the negative relation between legality and total debt is only present for firms without FC debt. Second, we find that this negative relation holds for both short-term and long-term debt but it is stronger for short-term debt (consistent with Demirguc-Kunt and Maksimovic, 1999). Next, we find that firms with FC debt residing in countries with poor legality, both borrow less in local currency (short-term and long-term) and more in foreign currency than similar firms residing in countries with strong legality. Thus, for firms with access to foreign debt there is _no_ significant difference in total debt ratios across legal regimes because firms from countries with poor legality make up for the lower local currency debt by borrowing more in foreign currency. Finally, we show that, as predicted (and consistent with Fan, Titman, and Twite (2003)), the long-term local currency borrowing is positively affected by legal efficiency, but that firms react to this by adjusting the use of longterm foreign currency debt. Our results are robust to alternative measures of legal effectiveness and alternative specifications.

> section, a large part of foreign lending to firms from weak legal environments relies on off-shore accounts (and jurisdictions) or foreign denominated receivables (e.g., export revenues) that act as collateral.

> 4 To be precise, the categories are (1) firms with foreign currency debt and (2) other firms, some of which we know do not have foreign currency debt and some for which we have no information about.  If this uncertainty induces a systematic bias, it will be against our findings.

3
In addition to examining the question of how legality is related to firm debt, we also briefly discuss how FC debt markets are able to bypass poor legal systems of firms’ home countries. Mechanisms include foreign assets or cashflows that can act as collateral as well as guarantees from foreign shareholders or customers. For example, the ability to seize a collateralized asset in the case of default depends on the quality of enforcement of the country in which the asset is located.

Our results have important implications for the understanding of financing growth around the world and imply that foreign currency debt can supply necessary funds, otherwise unavailable to firms operating in poor legal environments. Our results suggest the need for further research into this important mechanism for obtaining capital, for example, new research that seeks to understand the characteristics of the fund suppliers.

The remainder of the paper is organized as follows: Section II discuss the extant related research, provides examples of existing structures of foreign currency borrowing, and develops our hypotheses. Section III describes the data. Section IV presents the results from our statistical tests and Section V concludes.

# **II.   Related Research and Hypotheses**

## **A. Related Research**

La Porta et al. (henceforth LLSV, 1998) show that legal origin (English, French, German, or Scandanavian) is associated with the level of creditor and investor protection. In a related paper LLSV (1997) find that although aggregate debt levels vary by country, creditor rights and legal origin cannot explain it. They conjecture that a relation between debt and legal structure may not exist since large amounts of debt financing in developing countries is given through government financial intermediaries (who are unlikely to be deterred by weak legal rules). In addition, they note, “The striking result is that our debt measure for large firms does not vary 4
nearly as much as the aggregate measure: large publicly traded firms in countries with low aggregate debt do not have unusually low debt levels.” Leuz and Oberholzer-Gee (2003) examine financing by Indonesian firms before the Asian crisis of 1997 and find support for LSSV’s inference that governments facilitate local lending to large companies. More specifically, firms with close political ties to the Suharto regime are more likely to get low-cost loans and less likely to access foreign capital markets. Thus, political ties and foreign markets can act as something of substitutes in the market for external capital.

An extensive body of finance literature also studies firms’ capital structures. For example, models premised on tax shields and financial distress costs (static trade-off), information asymmetries (Barclay and Smith, 1995, and Titman and Wessels, 1988), agency costs (Fama and Miller, 1972, Jensen and Meckling, 1976 and Jensen, 1986) and signaling (Ross, 1977) are all part of the standard capital structure literature. Harris and Raviv (1991) provide a comprehensive survey of the capital structure literature and find that debt use is positively related to fixed assets, nondebt tax shields, investment levels and firm size and negatively related to cash flow volatility, growth opportunities, advertising expenditure, probability of bankruptcy, profitability and uniqueness of product.

The capital structure literature has also directly examined the effect of laws and legal efficiency on external financing decisions. In particular, research has looked at important institutional differences such as legal contracts and their enforcement across countries and noted that this can be an important factor for firm-level capital structure. Analytical frameworks based on agency costs and residual control rights (Jensen and Meckling, 1976; Hart, 1995) are based on “adequate”– and alike – investor protection across countries. Studies such as Hart and Moore (1995) examine optimal capital structure when investors cannot enforce legal rights.

Recent empirical research has examined firms’ capital structures using international data. Rajan and Zingales (1995) investigate the determinants of capital structure for G-7 countries 5
conditioning on (among other factors) differences in bankruptcy codes and find that leverage is fairly similar across countries, despite sharp differences in the specific institutional processes for handling financial distress. Aivazian et al. (2001) examine capital structure in 10 developing countries and conclude that debt ratios in developed and developing countries are determined by similar factors but that country-specific factors appear just as important. However, the authors do not specifically examine the role of legal structure or effectiveness. Fan, Titman, and Twite (2003) examine leverage amount and maturity across 47 developed and developing countries and find evidence that the corruption level is positively associated with high leverage and with more short-term debt but they find no relationship between common law and leverage.

Gianetti (2003) considers the effect of legal rules, firm-specific characteristics, and the level of financial development on corporate financing decisions for a sample of private and listed European firms. The study documents a positive relation between access to long-term debt and strong legal rules and enforcement. Firms in countries that favor creditor rights are more leveraged and have a higher proportion of long-term capital.

Demirguc-Kunt and Maksimovic (1999) examine debt maturity in 30 developed and developing countries from 1980-1991 and find important differences in the use of long-term and short-term debt. Specifically, larger firms in countries with good legal systems have more longterm debt relative to assets and a longer average maturity of debt. Similarly, large firms in countries with more effective legal systems have less short-term debt. The relation between legal effectiveness and long-term debt is weaker for smaller firms. Overall, these results are consistent with the arguments of Diamond (1991, 1993) and Rajan (1992) that short-term financing is preferred when it is more likely that borrowers could defraud lenders. However, like LLSV, Demirguc-Kunt and Maksimovic find little evidence that the legal tradition (e.g., common or civil law) is important for determining the use of long-term debt relative to assets or debt maturity. They also find that, consistent with the suggestion of LLSV, the use of long-term debt by both large and small firms is positively related to the level of government subsidies.

6
However, due to paucity of data on foreign currency denominated debt, the literature largely ignores the role of domestic versus foreign debt and the effect it may have on the observed relation between legal effectiveness and debt capital. A few studies have examined the issue tangentially. For example, Allayannis, Brown and Klapper (2003) study the use of foreign debt in East Asia and find that the motivation to use foreign debt is largely motivated by perceived differences on the cost of funds and the need to access deeper financial markets. However, they find that legal origin does not provide additional explanatory power beyond differences in interest rates and tax policies.

Overall, the relation between legal effectiveness and the use of debt appears dependant on, the sample, the type of debt variables examined, and the specific measures of legal structure. In addition, previous studies do not analyze the interactive relations between legal effectiveness and the currency denomination of debt. We hypothesize that explicitly considering the fact that many firms raise both long-term and short-term debt capital in foreign markets may resolve some of these conflicting results. In other words, only by looking at the breakdown of debt by currency _and_ maturity (i.e. short-term local currency debt, short-term foreign currency debt, etc.) can the impact of legal effectiveness on the use of debt capital be properly analyzed.

# **A. Hypotheses**

To motivate our empirical analysis we propose hypotheses relating the use of different types of external capital to legal effectiveness. LLSV (1997, 1998) conjecture that differences in effectiveness of legal systems will result in differences in investor protection that will in turn affect the availability of external equity and debt capital. Their predictions are summarized by the following hypothesis.

_Hypothesis 1: Poor legal quality results in less external capital, thus there should exist: i. a positive relation between legal effectiveness and the amount of external equity, and ii. a positive relation between legal effectiveness and the amount of debt._ 7
An alternative hypothesis suggested by the theoretical results of (Diamond, 1984, 1991,1993) and the empirical results of Demirguc-Kunt and Maksimovic (1999) and Gianetti (2003), among others, suggests: _Hypothesis 1A: Poor legal quality implies that external capital will be concentrated in debt (via intermediaries) and in particular short-term debt thus there should exist:_

- _i. a positive relation between legal effectiveness and equity, and_

- _ii. a negative relation between legal effectiveness and total debt, and_

- _iii. a positive relation between legal effectiveness and debt maturity._

These hypotheses are predicated on the binding nature of the local legal system. If creditors and borrowers can avoid a poor local legal system by writing debt contracts that are enforced in countries with better legal systems, as we described earlier, then these predictions should only apply to local contracts. Since poor legal effectiveness is likely to be a binding constraint that results in less than optimal lending, we expect firms that can use foreign currency to loosen this constraint, will do so. Therefore, we suggest the following hypothesis.

_Hypothesis 2: When possible, firms will avoid the constraints of a poor legal system by contracting for debt outside their home country (i.e., by using foreign currency debt), thus there should exist:_

- _i. no relation between legal effectiveness and total debt or debt maturity for firms with sufficient access to foreign debt, and_

- _ii. a positive (negative) relation between legal effectiveness and the use of both shortterm and long-term local (foreign) currency debt._

In summary, observed empirical relations that appear contradictory can be explained by separately examining local and foreign currency debt.

# **III.   Data**

We rely on two primary data sources for our study. The first is firm-level accounting data from the WorldScope Database. We examine all non-financial firms with sufficient data for fiscal year 1996 in nine East Asian countries: China, Hong Kong, Indonesia, Malaysia, The Philippines, Singapore, South Korea, Taiwan, and Thailand. All together our sample includes 8
1,689 firms. By country, our sample size ranges from a low of 71 firms in the Philippines to a high of 309 firms in Malaysia (see Table 1).

We calculate external capital ratios for equity and both short-term and long-term debt. External equity is defined as the market value of equity multiplied by one minus the average percentage of market capitalization closely held as reported by Dahlquist et al. (2003, p. 95). Following LLSV, we calculate capital ratios by dividing external capital measures by total sales.<sup>5</sup> We calculate several control variables that have consistently been shown to be related to capital structure such as firm size (log of sales in U.S. dollars), asset tangibility (fixed assets as a percent of total assets), profitability (operating margin), and the ratio of market-to-book value of equity.

WorldScope does not have data on the currency denomination of debt so we rely on a database created by Swiss Bank Corporation – Warburg Dillon Reed (SBC-WDR) that estimates the level of both short-term and long-term debt in local and foreign currency. This is the same database examined by Allayannis, Brown, and Klapper (2003) and includes data on 315 firms from the same East Asian countries; 179 firms out of the 315 have foreign currency debt. Additional details regarding these data are available in the appendix of Allayannis, Brown, and Klapper (2003).

Our measure of legal effectiveness is the “Legality” index generated by Berkowitz, Pistor, and Richard (2003). The variable is generated by taking the first principal component of the five “enforcement” variables reported by LLSV (1998). Specifically, _Legality = 0.381*(Efficiency of the Judiciary) + 0.579*(Rule of Law) + 0.503* (Corruption) + 0.349*(Risk of Expropriation) + 0.384*(Risk of Contract Repudiation)_ This measure (the first principal component) accounts for 84.6% of the variance in the five measures. Berkowitz, Pistor, and Richard (2003) do not report a legality index for China, therefore we compute this value by regressing the _International Country Risk_ (ICR) Financial

> 5 LLSV also examine the external capital measures standardized by profits but we do not, because we concentrate on firm-level analysis and not all firms are profitable.

9
Risk Index on the available values of legality and using the predicted value of 14.6 for China.

Alternatively, omitting the 98 Chinese firms from all of the subsequent analysis leaves the results and conclusions unchanged.

# **IV.   Analysis**

In this section we describe the tests of our hypotheses and the results from these tests. Our main hypothesis is that foreign debt allows firms which reside in countries with poor legal systems to overcome borrowing constraints in their local markets and thus to achieve their preferred level of debt financing. Our starting point is a descriptive examination similar to LaPorta et al. (1997) of external equity and debt capital that firms use and the relation to legal environment. We aggregate to the country level and compare external capital ratios with a country’s legal environment.<sup>6</sup>

## **A. Main Results**

Our sample of 1689 firms from 9 East Asian countries spans the range of legal systems well: three countries have an English legal origin (Hong Kong, Malaysia and Singapore), two have a German legal origin (South Korea and Taiwan), three have a French legal origin (Indonesia, Philippines and Thailand) and one has a socialist legal origin (China). Table 1 presents some descriptive statistics. Among the three primary legal origins the distribution of firms is fairly even ranging from 397 firms of French legal origin to 749 of English legal origin.

The next column shows the legality index for each country. Unsurprisingly, the highest average legality measures are found among countries with an English legal origin (average of 18.2), then among countries with a German legal origin (average of 15.8), and finally among countries with a French legal origin (average of 11.0). China has a legality index that is roughly the same as the average of the German legal origin countries.

> 6 Country level data based on median cash-flow yields qualitatively similar results to those presented in Table 1.  Finally, using assets instead of sales did not make any difference in the results.

10
Columns 3 and 4 of Table 1 report the aggregate ratios of external market capitalization to sales and total debt to sales at the country level and then aggregated across legal origin. Consistent with LLSV (1997), these estimates suggest that the better the legal environment, (i.e., the higher the level of the legality index), the greater the relative value of external equity capital. The ratio of market-cap to sales increases from 0.34 for firms from countries with a French legal origin to 0.75 for firms from countries with an English legal origin. However, there is considerable variation in the measures at the country and firm level which is partly attributable to differences in industry mix, firm size, and other factors (as we show subsequently).

The total debt to sales ratios reveal a different story. Debt ratios across the legal origins are _inversely_ related to the legality index so that firms in French legal origin countries tend to have the greater values of debt . This result is in contrast with LLSV (1997) who find that legal origin is unrelated to the level of debt capital. Our later and narrower sample suggests a more extreme result that firms residing in countries with low legality measures have _more_ debt capital than firms residing in countries with high legality measures.<sup>7</sup> However, this result is consistent with the findings of Demirguc-Kunt and Maximovic (1999) and Fan, Titman, and Twite (2003).

We further examine the impact of legality on the structure of debt looking at short-term and long-term debt separately (columns 5 and 6 of Table 1). The alternative Hypothesis 1A predicts that debt maturity is positively related to legal quality hence firms in poor legality countries will tend to rely more on short-term debt. Consistent with this hypothesis, we find that firms residing in countries with lower legality measures tend to rely more on short-term debt than firms residing in countries with high legality measures. The ratio of short-term debt to sales decreases from 0.30 to 0.15 as we move from low legality (French origin) to high legality

> 7 Note that the negative relationship between legality and debt capital is not a “mechanical” relation expected as a result of our finding that legality is positively linked to equity. The ratio that we use reflects the magnitude of external capital in each country not relative levels of firm capital (such as a debt-equity ratio).

11
(English origin). Examination of the long-term debt ratio reveals a weak relation between legality and long-term debt. French and German legal origin firms seem to have roughly the same amount of long-term debt which is substantially more than English legal origin firms. Chinese firms have an overall reliance on debt and equity similar to firms from German legal origin but exhibit a higher (lower) reliance on short-term (long-term) debt.

To test our hypotheses more precisely we estimate regression models using firm-level data with equity or debt ratios as the dependent variables, legality as an explanatory variable and a set of control variables to account for other probable determinants of external finance levels. The first two columns of Table 2 show results from tests with the market capitalization and total debt ratios as the dependent variables using all firms in our sample. As suggested by the findings in Table 1 legality is strongly positively related to the amount of firms’ external equity capital and strongly negatively related to the amount of total debt. The positive relation for external equity is consistent with both Hypothesis 1 and its alternative. However, the negative relation for total debt is inconsistent with Hypothesis 1 (that total debt and legal quality are positively related). Instead, it is consistent with the alternative (that total debt and legal quality are negatively related). Thus, these results support the monitoring models of Diamond (1991, 1993).

It is interesting to note the relations between external capital and the other variables included in the regression. Larger firms with less tangible assets tend to have both less (or less valued) external equity and less debt. In contrast, more profitable firms have more (or more highly valued) equity but less debt which is consistent with the pecking-order theory and the results of many prior empirical studies (see, for example, Rajan and Zingales, 1995).

The remainder of Table 2 presents results from similar tests that examine firms based on their use of foreign currency debt. The third and fourth set of results repeat the analysis in the first two columns but only for firms we do not identify as having foreign currency debt. These results are nearly identical to those for the full sample in so far as there exists a strong positive relation between legality and external equity and a strong negative relation between legality and 12
total debt. Results for the control variables are also nearly identical to the full sample. Examining only firms with foreign currency debt yields different results from the full sample, but results consistent with our hypotheses regarding FC debt. The fifth column shows that the strong positive relation between external equity and legality also holds for firms with FC debt.

However, as predicted by Hypothesis 2 there is no relation between legality and total debt for firms with FC debt. Note that this result is not simply because the smaller sample size limits the power of the test—the coefficient value of -0.012 is close to zero (about one third of the coefficients obtained from the estimations using all firms and firms without FC debt). In addition, the firm-specific control variables are all significant at the 1% level. Similarly, the estimation with external equity (previous column) uses the same sample of firms and does not lack power. Finally, the adjusted R-squared is quite high—more than twice that of the other two specifications with total debt. In summary, this evidence is suggestive of our hypothesis regarding FC debt. To obtain more direct results, we now examine the use of FC debt in more detail.

We begin by examining the maturity of debt for firms with and without FC debt. Recall, the alternative Hypothesis 1A suggests that firms in low legality countries will have relatively more (less) short-term (long-term) debt. If FC debt allows firms to loosen the borrowing constraint imposed by legality, then we should expect no relation between maturity and legality for firms with FC debt. Columns 1 and 2 of Table 3 present the results on short-term and longterm debt for the sample of firms with no foreign debt. Consistent with our alternative Hypothesis 1A, we find that legality is negatively and significantly associated with short-term debt, thus indicating a higher reliance of firms in poor legality countries on short-term debt. However, we find a similar negative association between long-term debt and legality indicating that firms in low legality countries also use more long-term debt. However, the smaller magnitude of the coefficient on the legality variable suggests this is a somewhat less important effect for long-term debt. The third column reports the results of a more direct test examining the ratio of long-term 13
debt to all debt (the maturity ratio) and finds no significant relation between legality and debt maturity for firms that do not use foreign currency debt.

The last three columns of Table 3 repeat the analysis in the first three columns using only firms with foreign currency debt. The results are again consistent with our Hypothesis 2 which predicts that there will be no relation between the extent of debt use and legal effectiveness for firms with access to foreign currency debt markets. We note that the result also holds if we use the maturity ratio. So far our results are just suggestive of the role FC debt plays in determining the overall level of debt capital since we do not have detailed data on the currency denomination of debt for all the firms in our sample.

To distinguish more clearly the pivotal role of FC debt, we now limit our analysis to the 179 firms which use foreign currency debt. Table 4 contains our primary results. As a first cut, Panel A shows mean local, foreign, and total debt broken down by maturity for firms that reside in countries with an English legal origin (high legality) versus firms that reside in countries without an English legal origin (low legality). We begin by noting that the total debt ratios for English legal origin and other legal origin countries are not statistically different (1.170 versus 1.099 respectively). However, examination of the components of debt shows that there exist substantial differences in the composition of debt.

In contrast to the prior findings, the results are largely consistent with Hypothesis 1 that legal effectiveness is positively related to availability of debt. Firms in countries with an English legal origin use both significantly more local currency long-term debt and significantly less shortterm foreign currency debt than firms in countries with other legal origins. The results for LC short-term debt and FC long-term debt are suggestive of the hypothesized relation but not statistically significant (in a two-tailed nonparametric test). However, firms with FC debt in high legality countries use significantly more total local currency debt. Overall, the results in Panel A are consistent with the notion that access to foreign debt allows firms in low legality countries to 14
get around a borrowing constraint that may be binding for firms with access to only local currency debt markets.

Panel B of Table 4 reports the coefficients and _p_ -values for the legality variable for regressions similar to those in Table 3 (i.e., the regressions also include other firm-specific variables and 1-digit SIC dummy variables). Here the results are direct and clearly support our main hypothesis. The legality measure is positively related to both short-term and long-term (as well as total) _local currency_ debt. This is consistent with Hypothesis 1 that legal effectiveness is positively related to the use of debt. Likewise, the legality measure is negatively related to both short-term and long-term (as well as total) _foreign currency_ debt. This is consistent with Hypothesis 2 that firms with access to foreign currency debt will use it to overcome the borrowing constraints created by the poor quality legal environment. In the case of our sample, the firms are successful at this (perhaps because of their above average size) and the relation between legality and total debt in all currencies is not statistically different from zero. Finally, we note, primarily as a robustness check, that the relation between legality and the proportion of debt that is denominated in foreign currency is significantly negative (last column of Panel B).

The economic significance of the results in Panel B is surprisingly large. An increase of 10 points in the legality index (roughly equivalent to moving from Indonesia to Hong Kong) is estimated to on average i. increase the local currency debt ratio by 0.20 or about 46% of the mean value for all firms (0.433), and ii. decrease the foreign currency debt ratio by 0.29 or about -42% of the mean value for all firms (0.683) .

Thus, these magnitudes suggests that legal effectiveness has a substantial influence on the currency denomination of debt even though the effect on the total amount of debt large public firms obtain is not statistically significant.

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# **B.  Robustness of Results**

Overall, the results are robust to the inclusion of additional variables known to explain cross-sectional differences in capital structure and the use of FC debt such as family group ownership structure, a foreign equity listing, foreign currency cash flows, capital intensity, and the level of business risk. We do not include these because the variables are not available for all firms and they do not appreciably change the results. We also examine other measures of legal effectiveness such as creditor rights (from LSSV, 1998) and a categorical variable for legal origin (i.e., English=1, German/Socialist=2, and French=3) and obtain results similar to those reported.

Another concern is that the results are specific to East Asia or the time period studied. Robustness checks using other years and countries are hampered by a lack of detailed data for FC debt. However, we examined an additional sample that provides some additional insights. We take all non-financial firms in the WorldScope database in 2001 and split the sample by the level of foreign sales (as a percent of total sales). We assume that firms with low foreign sales (less than 10%) will on average face greater constraints in accessing foreign debt markets (as discussed in the next section).<sup>8</sup> We repeat the regressions reported in Table 3 and find that for all countries, all developing countries, and only East Asian countries in 2001 the coefficient on legality is on average three times greater in magnitude for firms with low foreign sales. However, the difference is only statistically significant for East Asian countries. In sum, this analysis provides some additional evidence consistent with the main hypothesis, but the results are weak probably because of less precise data on foreign currency debt.

> 8 Allayannis et al. (2003) find that firms with FC debt also have higher levels of foreign sales, income, and assets though many firms without FC debt also have nonzero values for these characteristics.  In addition, some firms without foreign sales access FC debt markets, thus foreign sales is a reasonable but imperfect measure for firm use of FC debt.  We chose the 10% threshold because it splits the sample of EA firms roughly in half.

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# **V.   Discussion**

The results from the previous section show that foreign currency debt is an important part of understanding the relation between capital structure and legal effectiveness. Nonetheless, the precise methods by which firms change the legal treatment of their debt is also interesting. In practice there exist many mechanisms by which firms avoid poor local legal environments. In this section we briefly discuss a few of them.

## **A. Bank Debt**

Relative to domestic banks, foreign banks have difficulty collecting local information. In addition, foreign banks are often unwilling to accept local collateral because of weaknesses in land and collateral titling, registration, and collection. Similarly, in the case of bankruptcy and asset disputes, the courts often treat foreign banks differently.<sup>9</sup> However, as our results suggest, foreign banks are able to make secured loans, even in lending environments that discourage domestic lending, by demanding foreign collateral including foreign assets, cash flow, and guarantors.

In general, foreign banks prefer to lend to firms with a proven track record of foreign earnings and expected future foreign cash earnings sufficient to make foreign-denominated loan payments. Prior to the East Asian crisis, foreign banks lent more to firms in the region with greater foreign cashflow and foreign cash reserves (Allayannis, Brown, and Klapper, 2003). For example, banks required borrowers to open offshore cash accounts (e.g. firms were required to have cash collateral in bank accounts in Singapore). In general, foreign banks were unwilling to make collateralized loans against local assets because of weaknesses in laws governing the securing of assets and the enforcement of contracts. For example, the cost of contract enforcement in East Asia is 66.3% of GNI per capita, versus 7.1% on OECD countries (Djankov, et al 2003).

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In East Asia and other emerging markets jurisdictions with weak property rights, foreign banks also use forms of collateral other than local fixed assets. For example, many firms use foreign guarantors, often at the foreign bank with which the guarantor has a relationship (e.g. some tire part manufacturers in Mexico receive guarantors from Goodyear Tire and Rubber Co. to borrow in the US). Foreign banks also allow stock shares as collateral. Prior to the East Asian crisis, foreign banks lending in Asia generally asked for significant margins. For example, in Malaysia, where this is a common practice, the ratio of the value of shares pledged as collateral was about 146 percent of total debt outstanding at the end of October 1997.<sup>10</sup> More recently, advances in technology have allowed foreign banks to collateralize future foreign-denominated export receivables flowing into an offshore collateral account. For example, these accounts may use real-time, on-line ledgers to track the financial transactions of borrowers. For instance, in East Asia, in 1999 China Offshore Shipping & Trading Co. (Costco) pledged future receipts from shipments that arise from U.S. companies shipping goods out of China. A special purpose vehicle was set up as the holder of future receipts to pay investors.<sup>11</sup> In Latin America, in 2003, Orix Trade Capital syndicated a U.S.$30 million pre-export finance loan secured by future dollar receivables flowing to a U.S. collateral account for Brazilian company Braskem.<sup>12</sup> And in Iran, in 2003 a consortium of international banks led by Deutsche Bank provided a finance package to the National Iranian Oil Company (NIOC), which is backed by an off-shore collateral structure based on oil agreements with reputable export trading companies.<sup>13</sup> Off-shore accounts have even allowed foreign lending to countries with very weak rule of law, such as the former Soviet Union states. For example, in Georgia, Citicorp financed the equipment to build a privately owned air traffic control system that will be repaid from revenues

> 9 See “Some Lenders Still Struggle in Asia,” Karen Richardson and Shawn Crispin, Wall Street Journal, March 1, 2004, p. A14.

> 10 “Local banks take long-term views”, Business Times, Dec 5, 1997.

> 11 Sclafane, Susanne, 1999, “New cover protects Asias investments”, National Underwriter, September 27.

> 12 “Orix arranges Brazilian pre-export finance,” Trade Finance, September 2003.

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Georgia receives from international aircraft crossing its air space. The revenues will be deposited in an account with the International Air Transport Association in Switzerland, from which repayments will be made.<sup>14</sup> Foreign banks have been successful in collecting assets located in jurisdictions with better legal protection. For example, in 1998 Lehman Brothers Holdings was able to freeze the foreign assets of Russia’s largest private retail bank SBS-Argo in parts of Europe following legal action in London, although Russia was in the process of nationalizing the assets of the bank in Russia.<sup>15</sup>

# **B. Other Arrangements**

Because of the difficulty and risk of collateralizing assets in a country with weak legal environment, firms may create wholly-owned offshore subsidiaries or even incorporate in a foreign country. For example, many Russian companies have incorporated offshore. Although this requires additional time and expense, greater legal protection is given to foreign banks that collateralize shares using offshore bank accounts of firms located in an offshore jurisdiction. In the case of Russia, the civil code prohibits the enforcement of security interests other than through the judicial proceedings (e.g. creditors may not seize collateral in the case of default before going to court), yet the judicial system in Russia ranks low in judicial enforcement. To enforce a contract in Russia takes about 160 days and costs over 20 percent of GDP per capita, relative to 17 days and 7 percent in OECD countries.<sup>16</sup> In addition, debtors can be granted a oneyear moratorium on enforcement and the claims of secured lenders are subordinate to several other categories of creditors. Furthermore, Russian courts have ruled hedging instruments (such as currency forward contracts) to be “unenforceable gambling contracts”, which reduces the

> 13  “Finance package signed for National Iran Oil Company”, 2003, Deusche Bank Press Releases, November 27.

> 14 “Ex-Im Bank, Georgia sign project incentive agreement”, Export-Import Bank of the United States, July 18, 1997.

> 15 “Lehman wins decision to freeze foreign assets of big Russian bank”, Wall Street Journal, Oct 1, 1998. 16  See http://rru.worldbank.org/DoingBusiness/default.aspx.

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ability of Russian firms to manage their foreign-denominated borrowing risk. Finally, it is not possible to pledge a Russian bank account or accounts receivable (expected cash).<sup>17</sup>

# **C.  Is Legal Effectiveness the Fundamental Factor?**

The implicit finding in our results is that a weak legal system does not eliminate the availability of local currency debt—it just raises the cost of it. This suggests that interest rates should be negatively related to the legality measure. Table 5 reports the difference between the London Interbank Offer Rate (LIBOR) and local (similar-quality) short-term interest rates as of the end of 1996. Interest rates in high legality (English legal origin) countries are quite low—on average below LIBOR. In German and Socialist legal origin countries (South Korea, Taiwan, and China) interest rates average about 4% higher than LIBOR. Finally, in French legal origin countries interest rates are the highest, averaging more than 6% more than LIBOR. Overall, the Pearson correlation coefficient between interest rates and the legality measure is -0.77. The strong correlation probably explains why Allayannis, Brown, and Klapper (2003) find that legal origin has no additional explanatory power beyond interest rates in their analysis of foreign currency debt use by East Asian firms.

This quick calculation suggests two things. First, the cost to firms of an ineffective legal system (in terms of the effect on interest rates) is probably considerable. Second, interest rate variables may represent sufficient statistics for describing the cost of a poor legal system. It also highlights one short-coming of our analysis. In so far as legal effectiveness is highly correlated with other country-specific factors, it is difficult with a small number of countries to statistically differentiate that legal effectiveness is the fundamental factor driving the results. For example, we obtain similar results using short-term interest rates instead of legality as an explanatory variable. However, intuition suggests that the level of equilibrium interest rates derives in part from the legal environment and that the converse is unlikely.

> 17 “Hurdles to overcome: Marian Hagler of Coudert Brothers looks at how borrowers and lenders in Russian corporate financings are coping with legal obstacles,” by Marian Hagler ,The Banker, May 2002.

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Other country-specific factors are somewhat more difficult to disentangle. For example, the efficiency of the banking sector or the size of the government bond market may help determine the supply of (especially long-term) local currency debt. The next column in Table 5 shows the relation between net interest margin for the commercial banking sector.<sup>18</sup> The strong negative correlation is consistent with firms in low legality countries seeking foreign capital because of an inefficient banking system. The last column of Table 5 shows the size of the government bond market as a percent of GDP. As expected, countries with poor legal quality have low levels of public-market government borrowing, thus this could also explain the positive relation between levels of local currency debt and legality. However, in both of these cases it is again likely that legal effectiveness is the driving factor. Banks will need to charge more for loans if recovering assets in bankruptcy is relatively more costly in a poor legal system. Likewise, the level of a government’s public borrowing may be a symptom of poor legal quality as well as a determinant of corporate long-term debt if lenders worry that poor legal quality extends to the government’s ability (or desire) to pay debtors. We believe the latter are more likely scenarios, but a detailed analysis is beyond the scope of this paper.

# **VI.   Conclusions**

The main findings of this paper are that: i. In East Asia, there exists a strong negative relation between the use of debt and the effectiveness of the legal system consistent with the monitoring theories of Diamond (1991, 1993).

- ii. When examining only firms known to have foreign currency denominated debt,

there exists no relation between legal effectiveness and total debt.

> 18  Net interest margin is considered a measure of banking efficiency and is defined as accounting value of a bank’s net interest revenue as a share of its total assets.  Values are from Beck, Demirguc-Kunt, and Levine (2000).

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- iii. Nonetheless, firms with foreign currency debt exhibit a positive relation between the use of local currency debt and legal effectiveness, as well as a negative relation between the use of foreign currency debt and legal effectiveness.  These relations hold for both short-term and long-term debt.

- iv. There are a variety of known mechanisms by which borrowers can effectively

- change the legal jurisdiction of their borrowing.

Thus, legal effectiveness can have opposite effects on the level of debt depending on whether or not the firm can borrow abroad. Specifically, for firms without access to foreign currency debt legal effectiveness seems to increase the attractiveness of debt perhaps because (especially shortterm) debt reduces the possibility that firms will be able to defraud external providers of capital. However, for firms that can bypass the local legal system and contract for debt in a more effective legal system, the role of legality is reversed. In this case firms borrow less local currency and more in foreign currency in support of the hypothesis that ineffective legal systems inhibit the availability of external capital. Taken together these results resolve apparent inconsistencies in existing empirical work and also indicate quite conclusively that poor legal quality acts as a costly constraint for many firms needing access to outside funds.

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