Markets and politics, revealing state business relation through financial market information

... Markets and Politics: Revealing State- Business Relation through Financial Market Information by Wee-Keng Lee, B.A (Honors), M.B.A., M.S... system characterized by active state intervention in the economy and close state- business relations in Southeast Asian countries 1.1 STATE- BUSINESS RELATIONSHIPS AND ECONOMIC DEVELOPMENT A great... Conditions and Political Process 62 3.3 Stock Markets and Political Events 65 3.4 Using Stock Price Data to Measure Regulatory Changes 69 viii 3.5 Business -State Relations And Economic

Copyright

by Wee-Keng Lee

2002

Markets and Politics: Revealing State-Business Relation through

Financial Market Information

by Wee-Keng Lee, B.A (Honors), M.B.A., M.S

Dissertation

Presented to the Faculty of the Graduate School of

The University of Texas at Austin

in Partial Fulfillment

of the Requirements for the Degree of

Doctor of Philosophy

The University of Texas at Austin

August 2002

UMI Number: 3099477

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Dedication

To all important women in my life: mother, wife and sisters

Acknowledgements

I want to express my heartfelt appreciation to the many people who helped bring the exhilarating and exhausting process of completing a dissertation to a successful conclusion I am especially grateful to all faculty members on my dissertation committee Dr Brian E Roberts deserves special thanks for his care and thoughtful guidance and for agreeing to accept yet another doctoral candidate into an already packed schedule Without his untiring patience, support, suggestions, and encouragement, I would have never completed this project A special, warm acknowledgement goes to Dr William P Glade for his kindness, support and encouragement A special tribute is extended to Dr Chooi-Kwa Lim,

my mentor, undergraduate professor and friend who encouraged my pursuit of graduate education in this country I am also grateful to Dr William Gissy for his encouragement, support and the confidence in me to complete the program In addition, I want to thank all my fellow cohorts, particularly Dr Pedro Gomis-Porqueras and Dr Risa Kumazawa for their moral supports and helps throughout the time I was engaged in this study

To Hsiu-Chen, my wife and my best friend, I remain forever grateful and indebted None of this would have been possible without her

Markets and Politics: Revealing State-Business Relation through

Financial Market Information

Publication No. _

Wee-Keng Lee, Ph.D

The University of Texas at Austin, 2002

Supervisor: Brian E Roberts

The phenomenon of crony capitalism is often described as the major cause

of the Asian economic collapse in 1997 The main objective of this study is to address this phenomenon empirically through the structure of Malaysian political economy and tests the hypothesis that crony firms earn positive abnormal returns There are claims that crony capitalism is widespread in the country Since crony firms should earn positive abnormal returns as a result of regulatory changes, market information should reveal evidence of the existence of cronyism

This empirical research represents an effort to fill the research gap of the limited empirical study in crony capitalism, in particular and the understanding of Malaysian political economy in general This study improves upon previous case

data on daily stock prices instead of accounting data or corporate annual reports The former is more reliable than the latter since providing misleading information

is not unusual for firms or governments in developing countries

Three major political events in the past decade that greatly impacted economic policies in Malaysia are examined This study finds that the portfolio consistently experienced statistically significant abnormal returns after some major political events or new policies were announced The results suggest that political connectedness is one major factor affecting stock returns of firms in this portfolio

Table of Contents

List of Tables xi

List of Figures xii

List of Illustrations xiii

List of Abbreviations xv

Chapter 1: Introduction 1

1.1 State-Business Relationships and Economic Development 2

1.2 Defining Crony Capitalism 3

1.3 Malaysian Political Economy: A Brief Introduction 5

1.4 The Evolution of Crony Capitalism in Malaysia: A Preliminary Look 10 1.5 Markets and Politics 12

1.6 Statement of the Problem 14

1.8 Significance of this Study 15

Chapter 2: Political Economy of Malaysia 17

2.1 Politics in Malaysia since independence 17

2.1.1 Leadership 19

2.1.2 The Mechanics of Elections 37

2.2 Economic History 41

2.2.1 The Malaysian Economy: Overview 41

2.2.2 New Economic Policy (NEP): 1971-1990 45

2.2.3 National Development Policy (NDP): 1991-2000 52

Chapter 3: Literature Review 57

3.1 Politics of government decision-making 58

3.2 Economics Conditions and Political Process 62

3.3 Stock Markets and Political Events 65

3.4 Using Stock Price Data to Measure Regulatory Changes 69

3.5 Business-State Relations And Economic Development in East Asia 71

3.6 Malaysia: Related Literature 74

Chapter 4: Methodology and Data 78

4.1 Event study design 78

4.1.1 Identifying the Event of Interest 79

4.1.2 Model the Security Price Reaction 81

4.1.3 Estimate the Abnormal Returns 84

4.1.4 Aggregation of Abnormal Returns 85

4.1.5 Analyze the Results 86

4.2 Data 87

4.3 Criteria for firm selection 88

4.4 Kuala Lumpur Stock Exchange (KLSE) 89

Chapter 5: Findings 92

5.1 Event 1: 1990 General elections and privatization master plan 92

5.1.1 Pre-Event: 1987 UMNO General Assembly 92

5.1.2 The Event: 1990 General Elections 96

5.1.3 Post Event: the Privatization Master Plan 100

5.1.4 Empirical Study 101

5.2 Event 2: 1993 umno general assembly 103

5.2.1 Pre-Event: The Rise of Anwar and His Corporate Links 103

5.2.2 The Event: 1993 UMNO General Assembly Election 105

5.2.3 Post Event: New Landscape of Business-State Relations 107

5.2.4 Empirical Study 108

5.3 event 3: 1998 capital control 111

5.3.1 Pre-Event: The 1997 Asian Financial Crisis 111

5.3.2 The Event: Capital Control 113

5.3.3 Post-Event: The Aftermath 119

5.3.4 Empirical Study 120

Chapter 6: Summary and Conclusions 123

6.1 Limitations of the Study 123

6.2 Discussions and Summary 126

6.2.1 Event 1: The 1990 General Elections 126

6.2.2 Event 2: 1993 UMNO General Assembly 129

6.2.3 Event 3: Capital Controls in 1998 130

6.3 Conclusion 133

6.4 Recommendations for Future Research 134

Appendix A: Excerpts from Existing Literature 136

Appendix B: Sample 139

Appendix C: Capital Controls 143

References 146

Vita 164

List of Tables

Table 1-1: Distribution of Ethnic Groups in Major Industries, 1970 7

Table 2-3: Parliamentary Election Results under Current Regime 40

Table 2-4: GDP Growth of Malaysia (%) 42

Table 2-5: Income Differentials by Race and Location, 1970-1989 48

Table 2-6: Number of SOEs, 1960-1992 49

Table 2-7: Sectoral Changes during OPP2 (%) 54

Table 5-1: Parliamentary Election (1986 & 1990) 99

Table 5-2: Empirical Result 1 (N=51) 101

Table 5-3: Empirical Result 2 (N = 69) 109

Table 5-4: Empirical Result 3 (N = 77) 120

Table 6-1: Selected Debt-Equity Ratio Before and After the Capital Controls 132

List of Figures

Figure 4-1: Time Line for an Event Study 79

Figure 5-1: Event 1-Average Abnormal Return 102

Figure 5-2: Event 2-Average Abnormal Return 110

Figure 5-3: Exchange Rates (RM:US$) 112

Figure 5-4: Composite Index July 1997-January 1998 112

Figure 5-5: Event 3-Average Abnormal Return 121

List of Illustrations

Map 1: Malaysia xiv

Map 1: Malaysia

Produced by the US Central Intelligence Agency

List of Abbreviations

BA Barisan Alternatif

BCIC Bumiputera Commercial and Industrial Community

BN Barisan Nasional

BNM Bank Negara Malaysia (the Central Bank)

CAR Cumulative Average Residual

DAP Democratic Action Party

DJIA Dow Jones Industrial Average

EOI Export-Oriented Industrialization

EPF Employees Provident Fund

EPU Economic Planning Unit

GDP Gross Domestic Product

HICOM Heavy Industries Corporation of Malaysia

ISA Internal Security Act

ISI Import-Substitution Industrialization

KLSE Kuala Lumpur Stock Exchange

KSM Koperatif Serbaguna Malaysia

KUBB Koperasi Usaha Bersatu Berhad

MCA Malayan Chinese Association

MIC Malayan Indian Congress

MP Malaysia Plan

MPHB Multi-Purpose Holdings Berhad

MSC Multi Media Corridor

NCC National Consultative Council

NDP National Development Policy

NECC National Economic Consultative Council NEP New Economic Policy

OLS Ordinary Least Squares

OPP Outline Perspective Plan

PAS Partai Islam Se-Malaysia

RM Ringgit Malaysia (Malaysian Currency) SOEs State-owned Enterprises

Sdn Bhd Sendirian Berhad (Private Limited) SME Small and Medium-scale Enterprises UMNO United Malays National Organization WTO World Trade Organization

to market distortions and therefore create impediments prohibiting economic growth On the other hand, decades of double-digit economic growth in the Newly Industrialized Countries (NIC) of East Asia such as Japan, Taiwan and South Korea, present a persuasive argument for active state intervention, particularly in developing countries World Development Report (1997) best summarizes the role of the state in economic development: “State-dominated development has failed, but so will stateless development Development without

an effective state is impossible” (p.25)

The economies of Southeast Asia countries, as a group, had achieved tremendous growth during the past three decades; this progress, however, was abruptly halted by the financial crisis in the second half of 1997 Most of these

countries had modeled their development process on the experience of the East Asian NICs Consequently, it is not surprising to observe a capitalist system characterized by active state intervention in the economy and close state-business relations in Southeast Asian countries

1.1 STATE-BUSINESS RELATIONSHIPS AND ECONOMIC DEVELOPMENT

A great deal of research has examined the distinct nature of the relations between state-business in this region (Jomo et al., 1997; Islam and Chowdhury, 1997; Wu and Chu, 1998, Huang, 2001) There are two prevailing views on this close state-business relationship In one favorable view, a close state-business relationship is a necessity in the presence of market failures State involvement is believed to help in coordinating investment activities and overcoming the problem

of asymmetric information; these interventions are important in the early stages of economic development, where productivity gains are large but the risk is high (Rodrik, 1995) Close state-business relationships also provide access to credit that otherwise might not be available and lower the cost of credit Wade (1990) argues that Asian states were able to “govern the market” to create their own success A close state-business relationship is, therefore, one of the major causes

of the “miracle” in this region (Johnson, 1987; Haggard, 1988; Chu, 1989)

The other more negative view mostly arose after the financial crisis in

1997 This view labels this close state-business relationship as “crony capitalism” and sees it as a self-imposed blockage to development, leading to inefficiency in resource allocation Many who share this view argue that when the state is

opportunities become entrenched With close relationships to the state, firms are able to obtain and abuse privileged information and market power to prevent market competition Rapidly expanding credit, explicitly or implicitly underwritten by the state, together with inadequate oversight, encourage the mismanagement and inefficient allocation of risk, or moral hazard As a result, there is over investment in risky and unproductive projects in this region

Accordingly, the nature of the state-business relationships undoubtedly contributed in an important way to recent financial crises in the region (Corsetti et al., 1998; McLeod, 2000; Wei and Sievers, 2000) Without uprooting the institutional structure of “crony capitalism,” as suggested by the International Monetary Fund (IMF), the prospects of recovery from the crisis in this region are dim Many analysts even anticipate the recurrence of the crisis in the near future if crony capitalism still prevails in these economic systems

1.2 DEFINING CRONY CAPITALISM

Although there exists no formal definition, the term “crony capitalism,” in general, is associated with big business conglomerates and politics Most observers see crony capitalism as a variety of capitalism where the dominant political leaders use the power of the state to make decisions in the best interests

of a particular set of well-connected businesses, rather than in the best interest of the market as a whole (Girling, 1997; Chang, 1998; Krugman, 1998; Wade, 1998; Haber, 2002) Crony capitalism is also defined as a capitalist economy where contracts and appointments are awarded to friends and families, rather than by tender or merit In time of financial crises, the state usually bails out or rescues

these friends and families, frequently using the rational of national interest To economists, crony capitalism generally implies collusion between the state and business, allowing, for example, illicit transactions, insider trading, and preferential tax exemptions that eventually undermine the market process

Personal relationships and patronage have long been a part of politics and business in this region Historically, Southeast Asia lacked the proper institutional frameworks that provide a stable business environment Operating under the fears

of being expropriated by oppressive states, in addition to the absence of reliable information, businesses in this region have gravitated toward a trading style based

on personal relationships Furthermore, these relationships also allow firms to raise capital informally within their networks Cultivating a good relationship with officials, either in a capitalist system such as Japan or in a command and control economy such as China, makes perfect business sense since governments have been actively involved in national economies

In the Asian context, as argued by many Western critics, crony capitalism

is beyond collusion between the simple state and business (Johnson, 1987; Haggard, 1988; Chu, 1989; Wade, 1990 and 1998; Chang, 1998) It is also a term

applicable to the inter-firm network that made up such business groups as keiretsu

in Japan, chaebol in South Korea, and the overseas family-owned Chinese

conglomerates in Southeast Asia It is a common practice for firms in a group to own each other’s shares and loan each other money, thus creating a web of interlocking ownership and indebtedness (Hamilton, 1999)

The practice of crony capitalism is widespread and is not limited to East Asia Governments in Latin America and Africa are not exempt from practicing crony capitalism (Haber et al., 2002) Asset holders are reluctant to invest in a country where the government has the ability to arbitrarily abrogate property rights even if the rates of return are high; unless the government can create a credible commitment not to tax away all of the rents created by property rights or completely abrogate those rights Haber et al (2002) argues that the crony economic system is the second-best solution to the commitment problem Citing the long history of crony capitalism in Mexico, they demonstrate how crony systems get re-created over time even in the face dramatic regime changes The major factor that allows such re-creation is the commitment problem in the absence of limited government

Krueger (2002) shows that this inefficient system has three major drawbacks to sustain economic growth First, crony capitalism encourages the misallocation of resources Second, since the commitments of the government are credible only so long as that particular government is in power, all cronies will operate under short time horizon and completely avoid any long-term investment Third, such system benefited only some privileged asset holders and therefore, it has negative consequences for the income distribution

1.3 MALAYSIAN POLITICAL ECONOMY: A BRIEF INTRODUCTION

Malaysia is a plural society with a total population of 23.26 million in

2000 (Malaysia, 2001a) The pluralistic nature of its population remains one of the distinguishing features of this country Malay represents the dominant ethnic

group, comprised 47 percent of this total Chinese (24 percent) and Indian (7 percent) are two other major ethnic groups in the country For political and economic purposes, the population of Malaysia is divided into two categories, Bumiputera (prince of the soil) and non-Bumiputera In addition to the Malay, the category of Bumiputera includes various indigenous groups, which represent 11 percent of the total population, clearly making the Bumiputera the majority group

in the country (58 percent)

The structure of the political and socio-economic institutions in Malaysia was the result of British colonization (Andaya and Andaya, 2001; Gullick, 1992; Cowan, 1961) The British hegemony began in 1786 with the foundation of Penang, followed by Singapore in 1819, and Melaka in 1824 These three cities were also the busiest ports along the Straits of Malacca In exchange for the control of this colony, the British granted generous monetary allowances to Sultans of the Malay states

The most significant legacy of the British colonial era was the dramatic demographic change that resulted in the emergence of the pluralistic society (Drabble, 2000) During the high production period of rubber and tin, two most important commodities in this colonial economy, in the late eighteenth and early nineteenth century, the British allowed a massive influx of low-cost immigrant labors from China and India into the country The unintended consequence of this open-door immigration policy is the ethnic division between Malays and non-Malays (principally Chinese) in occupation and location The Malays were displaced in the local economy following the massive inflow of labor, since they

seemed unwilling to work for wages in rubber estates or tin mines (Andaya and

Andaya 2001) They remained in the rural regions as peasants and fishermen

Furthermore, the colonial rural education policy which aimed, “to make the son of

a fisherman or a peasant a more intelligent fisherman and peasant than his father,”

also reinforced this ethnic and socio-economic division between Malays and

non-Malays (Snodgrass 1980) This division between non-Malays and non-non-Malays

continued to widen as large number of Chinese moved from employment in

rubber estates and tin mines, to commercial occupations (see Table 1-1)

Table 1-1: Distribution of Ethnic Groups in Major Industries, 1970

Industry Malays (%) Chinese (%) Indians (%) Agriculture, forestry &

When the Federation of Malaya gained its independence from Britain on

August 31 1957, a political coalition called the Alliance formed the first

government in this new state The Alliance was comprised of a Malay-based

party, United Malays National Organization (UMNO), a Chinese-based party, the

Malayan Chinese Association (MCA); and an Indian-based party, the Malayan

Indian Congress (MIC), with UMNO as the dominant party The first decade of

the governance of this newly independent country can be described as a decade of inter-elite bargaining, with “Malay political hegemony in return for unhindered Chinese (and Indian) economic activity” (Case, 1996) This multi-ethnic compromise approach seemed to work well in stabilizing the country, until the

1969 racial riot

Under the relatively laissez-faire approach in economic policy, Malays made only trivial advancement on their economic well-being as a result of economic segmentation and uneven economic development The new government believed in the trickle-down effect in development and spent more than 50 percent

of its budget on the infrastructure development in urban areas Consequently, the income gap between Malays and non-Malays was widening and poverty was prevalent in the Malay-populated rural regions

Feeling the increased economic weakness, the Malays discerned the vulnerability of their political dominance (Jesudason, 1989) They were disgruntled by the UMNO leadership, which made too many economic concessions to the non-Malays This led to diminishing support of UMNO On the other hand, non-Malays were dissatisfied with their representative parties respectively, for the inability of their leaders to obtain automatic citizenship after independence As a result, the Alliance experienced a major setback in the 1969 general election, in which it lost its two-third majority in the Parliament as well as control of two states

The intense inter-racial conflict mounted during the election campaign; riots finally broke out after the 1969 general election, which eventually brought

down the first post independence government Parliament was suspended and the country fell under the control of National Operations Council With the introduction of new political game rule wherein the opposition gained a stronger voice, the Alliance was also restructured after the 1969 racial riot It became the Barisan Nasional/National Front (BN), which has ruled the country since

The New Economic Policy (NEP), an affirmative action program, was established by the new administration in 1970 This was a 20-year economic plan, aimed at the “eradication of poverty” irrespective of race; and “restructuring society” by removing the association of ethnicity and occupation (Means, 1991)

In order to achieve these two major objectives of the NEP, the government introduced a quota system based on ethnicity mix in population To eliminate poverty and to improve income distribution, for example, the government granted all public projects to Bumiputeras, in addition to the provision of access to credit Bumiputera trust funds were created by the government to increase their ownership of local businesses to at least 30 percent by the end of the NEP To expand the skills of Bumiputera in other occupations, such as managerial, engineering and medical, 55 percent of university enrollments were reserved for Bumiputeras The NEP was ended in 1990 and was replaced by a similar long-term plan, the National Development Policy (NDP) launched by current administration

1.4 THE EVOLUTION OF CRONY CAPITALISM IN MALAYSIA: A PRELIMINARY LOOK

Close state-business relationship in Malaysia was apparent since the independence from Britain During the inter-elite bargaining period in the first decade of self-government, non-Malays, particular the Chinese, received numerous concessions from the Malay-dominated government These includes exclusive license to operate banks and other financial institutions In exchange, these Chinese businesses also channeled large amount of funds for the Alliance’s operation through the MCA, (Milne and Ratnam, 1965)

The seed of crony capitalism was sowed during Tun Abdul Razak’s administration, with the implementation of the NEP This affirmative action program achieved its goal of poverty eradication by reducing the poverty rate in the country from 49 percent in 1970, to 12 percent in 1989, albeit that the government has viewed the poverty in absolute terms in relation to a poverty line, rather than in relative terms such as inequality However, it is the second goal of the NEP, the society restructuring, that many critics believe, fostered the development of crony capitalism in the country (Yoshihara, 1988; Gomez and Jomo, 1997)

The NEP restructuring process involved redistribution of corporate stock ownership, employment and education The latter two were addressed in the education reform in the NEP, particularly in tertiary education Concern with the redistribution of corporate ownership was significant among the elite minorities

They strongly opposed this idea because they were afraid of state expropriation under the guise of advancing ethnic interest

Recognizing the fears of these elite minorities and to avoid further destabilization of the economy, the new administration chose to establish more state-owned enterprises (SOEs) and Bumiputera trust agencies in achieving its wealth-restructuring objective These SOEs were awarded with public projects such as water supply, telecommunications, waste collection and civil aviation To ensure racial harmony in the country and to avoid a zero sum game, these SOEs and trust agencies took over the control of many established foreign corporations

in the country, mostly through purchasing stock in the market The number of SOEs increased from 23 in 1957 to 1,149 by 1992 (Mohamed, 1995)

The seed of crony capitalism finally blossomed before the end of the NEP when the fourth administration, which is also the current regime, first announced its privatization policy in 1983, although the plan was not fully released until

1991 (Omar, 1990) Bumiputeras, who have a close relationship with the state, were rewarded handsomely in the privatization process These Bumiputeras include Malay capitalists, friends and families of high-ranking officials, retired high-ranking personnel in the armed forces and retired politicians In other words, the transfer of wealth only benefited a small group of Bumiputera elites, hoping that the trickle-down effect will be realized in the near future

Equally well rewarded are those Chinese businessmen who envisioned this privatization policy through privileged information These businessmen, realizing their disadvantages in obtaining government contracts under the NEP, invited the

Bumiputera elites, such as friends and family members of high-ranking officials, into their corporations They usually offer these Bumiputera elites some high-ranked positions that merely ceremonial, not positions that make crucial decisions With the presence of Bumiputeras in their corporate structures, these Chinese corporations also enjoy special treatment in the privatization program and protection from competition by the government

1.5 MARKETS AND POLITICS

A stock market has several characteristics that make it not only interesting, but also useful and important as an area in political study Stock market participants make daily decisions by drawing on a wide range of information, including relevant changes in the political environment They must judge the relevance of any given political event to the every firm’s prospective fortunes For example, the election of a particular party can be viewed as having either positive

or negative impact on business conditions and this expectation should be reflected

in the market The passage of certain regulations could generate firm-specific effects that lead to price fluctuation in the stock market In an efficient market, the current price should reflect all past and future information Prices instantaneously digest and adjust to the reception of new information If the outcome of a political event is anticipated, some anticipatory behavior should be evident in the period during to the event

Schwert (1981) has suggested that it is possible to use stock price data to measure the effect of regulation changes He further argues that tests with stock

economic rents as a result of regulation, the value of these rents will be included

in determining the value of the firm Thus, firms will seek regulations that increase stock prices and shareholder wealth Brown and Warner (1985) examine properties of daily stock returns and assess the stock price impact of firm-specific events Yantek & Cowart (1986) found a coherent and consistent view of how participants in the stock market combine self-interested economic calculations with judgments about economic benefits accruing to the partisanship of national officeholders Mitchell and Netter (1991) provide an overview on the use of financial data such as changes in stock prices in securities fraud cases in the U.S

The Kuala Lumpur Stock Exchange (KLSE) is of interest because there has been a history of government efforts to bolster the stock market in Malaysia, most apparently near the end of the NEP, in order to increase Bumiputera’s equity Established in 1973, KLSE was the second largest stock exchange in Asia

in terms of market capitalization (approximately RM900 billion), before the onset

of the 1997 Asian financial crisis, exceeded only by the Hong Kong Stock Exchange (Ahmad and Hussain, 2001) The market capitalization that was over

300 percent of GDP was substantially higher than any other economy (Henderson, 1998) KLSE also has the second most quoted companies among Asian bourses, only smaller than the number of quoted companies in Korea Stock Exchange There were days when the turnover on the KLSE was higher than that in New York!

Larger companies are listed on the Main Board while the smaller ones (with paid-up capital less than RM20 million) are listed on the Second Board As

of the beginning of 1995, the largest group of investors in the KLSE was small shareholders holding 500-5000 shares This group accounted for 76.4 percent of total investors in the KLSE The group of investors holding 10000 shares or more, though it represents only 7.8 percent of total investors, controlled close to 90 percent of total equity In terms of ethnicity mix, 17.3 percent of the total investors are Bumiputeras (controlling 31.8 percent of the equity of the listed companies), while non-Bumiputera and foreign investors make up of 69.7 and 13

percent respectively (Ahmad and Hussain, 2001)

The abuse of public position for private gain is not unusual in developing countries in Asia and Latin America (Haber et al., 2002) There are many examples and evidence in which politically affiliated firms have successfully affected the outcomes of government policy in both developed or developing countries Nevertheless, most published literature consists of case studies that identified politically affiliated firms or cronies by extracting information from news articles and company reports (Gomez and Jomo, 1997; McLeod, 2000) Existing literature usually identifies a firm as crony if the firm received preferential treatment in public projects or has retired high-ranking officials in the board of directors Such identification is potentially biased since efficiency of the firm or the skill and vision of the directors are implicitly ignored

Given that a politically connected firm or crony earns returns above those that would prevail in a market, and the fact that the political authorities will implement policies that would benefit its cronies, one should reveal more

evidence of the existence of cronyism through market information The lack of reliable firm information is one major reason for limited empirical research in crony capitalism This points to the need to explore and to utilize publicly available market information

The focus of this study is neither to locate the blame for the crisis in simplistic notions of crony capitalism, nor is it to evaluate if the practice of crony capitalism were economically rational in an inherently uncertain business environment The major objective of this study is to test the hypothesis that crony affiliated firms will earn positive abnormal returns after major political events or regulatory changes

1.8 SIGNIFICANCE OF THIS STUDY

Institutionalized behavior norms are difficult to change Political and economic reforms are difficult to realize without awareness of the general public concerning flaws in the current social norms If crony capitalism is believed to be the cause of recent financial crisis, a scientific method to expose such cronies is required, to provide more convincing evidence and to prevent the recurrence of the crisis

An event study is the research method used in this study to capture the change in returns of these firms after each regulatory change or political event occurs The Securities and Exchange Commission (SEC) also uses event studies

in collecting evidence in financial fraud cases in the U.S (Mitchell and Netter, 1991) This methodology has its foundation in the efficient markets hypothesis (Ball and Brown, 1968; Fama et al., 1969) According to this hypothesis, stock

prices should reflect all available information With the advancement in information technology and the reduction in transaction costs, stock prices will quickly adjust to the release of all available information and consequently, all agents earn only a normal rate of return As argued by Campbell et al (1997), event studies will “continue to be a valuable and widely used tool in economics and finance.” (p 180)

This empirical research represents an effort to fill the research gap of the limited empirical study in crony capitalism in particular and the understanding of the political economy in Malaysia in general Unlike most case studies in crony capitalism, this empirical study utilizes publicly available data on daily stock prices instead of accounting data The former is more reliable than the latter since providing misleading information is not unusual for firms or governments in developing countries Malaysia is one of the developing countries where crony arrangements are commonly practiced (Gomez and Jomo, 1997) In addition, the country has a well-developed financial market This unique characteristic makes Malaysia a prolific venue to conduct empirical research in crony capitalism

Chapter 2: Political Economy of Malaysia

In framing a government to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and in the next place

oblige it to control itself

— James Madison, 1788

Malaysia is a country physically divided into two portions by the South China Sea The western portion, which is officially known as the Peninsular, forms part of the southern projection from the Asian mainland, with Thailand immediately to its north, and Singapore to the south It has an area of 131,574 square kilometers and consists of the former Federation of Malaya with eleven states: Perlis, Kedah, Penang, Perak, Selangor, Negeri Sembilan, Melaka (Malacca), Johore, Pahang, Terengganu and Kelantan The eastern portion, which

is known as East Malaysia, is comprised of the state of Sabah and Sarawak and occupies the northern and northwestern coast of the Borneo Island (Malaysia, 2001b) These two states occupy an area of 198,447 square kilometers According

to the 1991 Census, approximately 19 percent of the total population lives in Sabah and Sarawak

2.1 POLITICS IN MALAYSIA SINCE INDEPENDENCE

The modern state of Malaysia was formed in 1963 by the union of the Federation of Malaya (which had achieved independence from Britain in August 1957), Singapore and the Borneo states of Sabah and Sarawak On August 9 1965,

Singapore was expelled from this Federation and became an independent state (Drabble, 2000)

The constitutional framework of the Malaysian political system is essentially democratic (Means, 1991) The first administration adopted the Westminster model without much modification Elections have been regularly held since independence The government is responsible to an elected parliament, and the judiciary system is constitutionally independent

Many political scientists, however, do not classify the political system in Malaysia as a democracy Instead, terms such as ‘limited’, ‘quasi’ and ‘semi’ democracy are usually used to describe the system since there exist both democratic and authoritarian characteristics in the political systems of Malaysia (Zakaria, 1989; Case, 1993) Since the 1969 racial riot, authoritarian controls became more prevalent in Malaysia with the increasing use of the Internal Security Act (ISA) The government is allowed to use this Act for preventive detention, most frequently used against opposition politicians, communists and social activists, without due process Nonetheless, the repressive government has

to be, at the same time, responsive, because of the competitive nature of the general election

The heterogeneous nature of the population tends to transform every political issue into a communal one and it is not a surprise that Malaysian politics has always revolved around ethnic issues (Mauzy, 1983; Means, 1991; Mandal, 2001) Political competition between Bumiputeras and non-Bumiputeras (principally Chinese) constitutes the major cleavage in Malaysia politics Despite

these ethnic divisions, the Malaysian polity is able to achieve some degrees of coherence that successfully provides a stable political order, which enhances rapid economic growth

2.1.1 Leadership

In 45 years of post independence there have been four changes in heads of government in Malaysia and ten general elections The Alliance (which later changed the name to the Barisan), which is led by UMNO, won all of the general elections and has formed the government since Independence Since UMNO is the predominant party in this political coalition, the president of UMNO automatically assumes the Prime Minister position in the Cabinet, and the deputy president of UMNO takes the position of Deputy Prime Minister (Means, 1991; Crouch, 1996) The four Prime Ministers are: Tunku Abdul Rahman, Tun Abdul Razak, Tun Hussein Onn and Dr Mahathir Mohamad Although the focus of this study is the crony capitalism during Mahathir’s administration, it is as important

to understand the leaderships of previous administrations The reason is that the New Economic Policy, which is believed to be the source of crony capitalism, started immediately after the first administration, and was completed under Mahathir’s administration

2.1.1a Tunku Abdul Rahman (1957-1970)

Tunku Abdul Rahman was the fourth son of the Sultan of Kedah, one of Malaysia’s oldest ruling families He led Malaysia to independence from British colonial rule in 1957 and became the first Prime Minister of the country until

1970 Like most leaders of the movement against British rule, Tunku Abdul

Rahman rose to power as a defender of traditional Malay rights in the multiracial society Nevertheless, he insisted on the retention of British links, parliamentary institutions, and the essentials of British law (Healy, 1982)

Shortly after the Japanese occupation in Malaysia (1942-1945), the British introduced the concept of the Malayan Union, in which the country would be governed by one central government based on equal civil and political rights for all, regardless of their ethnicity This move clearly upset many Malays, as they were very fearful of losing political control to the wealthier and more assertive Chinese in the country Led by the chief minister of Johore, Dato Onn Jaafar, the Malays were united under the newly established party, the United Malays National Organization (UMNO), which launched a massive campaign against the union proposal

During the peak of the nationalist movement, Tunku Abdul Rahman was working as a district official He had no vision of himself as the preeminent Malay leader Furthermore, since he received his education and spent many years

in Britain, he developed affection for the British and a solid understanding of British institutions It is not a surprise that Tunku Abdul Rahman had little sympathy for the more radical nationalist movement: he saw the British connection as beneficial (Healy, 1982)

Tunku Abdul Rahman was thrust onto the national stage after the resignation of Dato Onn Jafaar from UMNO due to differences in ideology The latter suggested the opening of UMNO to people of all races in order to promote inter-communal harmony This step seemed necessary as the non-Malays, mostly

Chinese, upset by not automatically being granted the citizenship, supported the Malayan Communists, which consequently forced the British authority to declare

a National Emergency in 1948 to contain communist insurrection However, majority members of UMNO insisted that the political birthright of the Malay was the only way to offset the economic strength of the Chinese As party support eroded, Dato Onn Jafaar and many of his supporters left UMNO and formed a new party, the Independence of Malaya Party (IMP) in 1951

Desperately in need for leadership, UMNO held its national conference in August 1951 At that time, Tun Abdul Razak, a brilliant young administrator of noble birth from Pahang state was the leading candidate However, Tun Abdul Razak proposed Tunku Abdul Rahman, his fellow student while studying in London, to be the president of UMNO Tunku Abdul Rahman eventually won the three-way election overwhelmingly

Tunku Abdul Rahman realized the importance of racial harmony in convincing the British authority that Malay and non-Malays could cooperate politically if granted independence (Cheah, 1999) He formed an alliance with the Malayan Chinese Association (MCA) in the first local government election in

1952 This embryonic UMNO-MCA alliance successfully won nine of the twelve seats in that election Encouraged by the success of this alliance in the local elections, Tunku Abdul Rahman accelerated the campaign for self-government from the British In 1954, the Alliance was gaining appeal as the front-runner to negotiate for the independence of the country when the Malayan Indian Congress

(MIC), which represents the Indian community, decided to join the Alliance (Healy, 1982)

The new Alliance, under the leadership of Tunku Abdul Rahman, once again assured the British that different communities would cooperate once self-government was granted, by winning all but one seat in the first national election

in July 1955 This convincing victory by the Alliance and the mounting financial burden of the war against communist insurrection prompted the British to grant Malaya its independence (Healy, 1982) On August 31 1957, Britain officially handed over the administration of the country to an elected Alliance government led by Tunku Abdul Rahman

During the formative years in this new country, Tunku Abdul Rahman emphasized political stability and multi-racial harmony Despite UMNO supremacy in the Alliance, Tunku Abdul Rahman also acknowledged the contribution of the non-Malays and expressed his willingness to make concessions According to Tunku Abdul Rahman, “the essence of Alliance bargaining was not equality but mutual dependency, combined with a willingness

to cooperate and accommodate.” (Means, 1991)

Tunku Abdul Rahman was highly engaged with the consolidation of this new country and seemed to have no long-term economic plan He was preoccupied with the concept of broader federation, for strategic reasons, by incorporating Singapore and the British Borneo territories (Sabah and Sarawak)

He succeeded in his pursuit and the Federation of Malaysia was formally inaugurated on September 16 1963 While Tunku Abdul Rahman was

concentrating on the federation, domestic communal conflicts were becoming more threatening His lack of a long-term economic plan, particularly one to improve the economic backwardness of Malay, finally took its toll

Shortly after joining the Federation of Malaysia, Lee Kuan Yew, the leader of Singapore’s ruling party, launched a campaign for a ‘Malaysian Malaysia’ urging communal equality and an end to Malay political predominance This campaign infuriated the Malays and led to a racial riot in Singapore in 1964 and the expulsion of Singapore from the Federation on September 19, 1965

Nonetheless, the inter-racial tensions did not subside with the expulsion of Singapore from the Federation The government introduced a controversial bill, the National Language Bill of 1967, which was aimed at making Bahasa Malaysia (Malay Language) the sole official language of the country (Means, 1991) Many Chinese leaders viewed this Bill as a threat to the freedom of using Chinese language as the medium language in the national education system They began making demands to the government for the assurance of Chinese education in the country and the establishment of a Chinese-language university

Dissatisfaction with Tunku Abdul Rahman’s administration in handling communal issues was reflected in the outcomes of the 1969 general elections For the first time, the Alliance lost its two-third majority in the Parliament by securing only 48.4 percent of the popular vote (Means, 1991) Feeling the threats and challenges to Malay predominance, some radical Malay leaders organized demonstrations in the capital, which eventually led to a major racial riot on May

13, 1969 The government proclaimed an Emergency and suspended the