The impact of country- and firm-level governance on capital allocation efficiency: New evidence from India

Abstract

This paper investigates the impact of country-level governance on corporate investment efficiency using data from Indian-listed firms between 2009 and 2022. Additionally, we explore how country-level governance interacts with firm-level corporate governance to influence investment inefficiency. Using World Bank's worldwide governance indicators, our findings from panel econometric models reveal that country-level governance and its subcomponents (political stability, government effectiveness, regulatory quality, rule of law, control of corruption, and voice and accountability) negatively affect investment inefficiency, underinvestment, and overinvestment. This suggests that robust governance at country-level serves as a control mechanism, reducing companies' likelihood of investing above or below optimal levels. Furthermore, we find that the effect of firm-level corporate governance (measured using a newly constructed governance index) on investment inefficiency is more pronounced in weak country-level governance environments, indicating a substitutive relationship. Similar patterns are observed in overinvestment and underinvestment scenarios. This evidence implies that when country-level governance is inadequate in mitigating agency conflicts and information asymmetries, firm-level corporate governance mechanisms become crucial for promoting investment efficiency. The robustness of our results is ensured through various methodological approaches. Sample selection bias is addressed using entropy balancing, while endogeneity concerns are mitigated with a combination of two-stage least squares, firm fixed effects, and a two-step generalized method of moments. Additionally, our findings remain consistent when using different proxies for both dependent and independent variables. Our empirical investigation provides valuable insights for regulators, policymakers, and corporate stakeholders in developing efficient investment policies.