Investor Protection and Exchange Rates

In the summer of 1997, several East Asian countries experienced a dramatic devaluation of their currencies both in nominal and in real terms, stock prices collapsed and output fell. Later in that year several Latin American countries were also affected, followed by Brazil and Russia in 1998. Johnson et al. (2000) provide evidence to support that the degree of outside minority shareholder protection explain the extent of exchange rate depreciation better than standard macro variables such as broad money growth, total reserves and import coverage. This paper provides an explanation for this finding in the context of a two-country equilibrium model (i.e. Korea vs. US) of real exchange rate determination. We argue that Korean firms are plagued by weak investor protection and entrenched controlling shareholders or entrepreneurs of these firms expropriate output from outside minority shareholders. The ability to expropriate minority shareholders is curbed by the extent of investor protection and by the controlling shareholder's own holdings of the firm as in La Porta et al. (1998, 2002). Because the expropriation is a function of the overall capital stock in the firm, weak investor protection leads to excessive investment rates by the entrepreneur and lower stock market valuations. This pattern is consistent with evidence that suggests that there was over-investment in Korea as well as in other East Asian economies. It is also consistent with the firm-level evidence in Baek et al. (2004) who show evidence of large declines in valuations in Korea during the 1997 financial crisis, particularly so in firms with weaker investor protection (see also Mitton (2002)). There are two goods in the world economy and countries specialize in the production of each good. There is free trade in goods and consumers (also the minority shareholders) can perfectly pool any risks internationally. The exchange rate is determined by the price of the Korean good relative to that of the US good. If Korean consumers have a preference for their home good, then the exchange rate depreciates and the relative price of the Korean good decreases when the demand for its goods decreases. In our model, as in Burstein, Eichenbaum and Rebelo (2003), a financial crisis is associated with a large drop in the net foreign asset position of Korean households. Because Korean households are also the ones with greater preference for their domestic good, this leads to a drop in their demand for the Korean good and a drop in the Korean good price. The upshot is a decline in the real value of the local currency. The magnitude of this exchange rate depreciation depends on the extent of investor protection. Weaker investor protection implies a more severe over-investment problem, more expropriation and lower output and dividend rates. Lower output leads to an overvalued exchange rate and implies greater sensitivity of the exchange rate to the financial crisis. Our model also predicts that a financial crisis that hits two countries that are identical in all respects but have different degrees of investor protection leads to a larger drop in the stock market valuation (denominated in local currency units) in the country with weaker investor protection