Does Institutional Quality Affect Firm Performance? Evidence From The Philippines, Indonesia And Viet Nam

Given the limited number of studies using Asian data on a firm-level analysis, this paper aims to fill in the gap by estimating a simple OLS model with fixed effects to examine how the [r]

DOES INSTITUTIONAL QUALITY AFFECT FIRM PERFORMANCE? EVIDENCE FROM THE PHILIPPINES, INDONESIA AND VIET NAM

Alyssa Cyrielle B Villanueva

School of Economics

De La Salle University alyssa.villanueva@dlsu.edu.ph

Abstract

Most research and case studies focused on obstacles that hinder firms’ ability to innovate such as the lack of access to finance This research looks at institutional quality as a hindrance to firm innovation Majority of the studies look at the relationship between institutional quality and firm innovation in countries located in the African, Latin American and Caribbean and Central Asian regions Hence, this calls for close analysis of the business environment and institutional quality

in Southeast Asia Using World Bank's 2009 and 2015 Enterprise Survey data sets for 3 countries in which data is available, the link between institutional quality (in the form regulatory quality and voice and accountability) and firm performance as measured by firm sales is examined in this paper The survey is used to estimate the return to firms’ innovation which also suggests that a country with better institutional quality have higher return to firms’ innovation Results call for government policies to be geared towards improving institutional factors to encourage the firms to innovate and invest research in developing new products

Keywords: Institutional quality, Firm innovation, Southeast Asia, OLS model, Fixed effects

1 Introduction

Firm’s innovation, particularly research and development (R&D), and technology adoption play

a key role not only in raising a firm’s competitiveness but it also serves as a main tool in driving economic growth Innovation capacity and firm performance is usually hindered by lack of access to finance new technologies that improve firm sales Girma et al (2008) reveal that

private firms without foreign direct investments and access to bank loans tend to innovate less In addition, the differences in ability to innovate and enhanced growth can be explained by differences in institutional quality Lin et al (2010) explain that the results of his study on Chinese firms using the World Bank Enterprise Survey (WBES) show that property rights protection and R&D activities are directly related to each other Anokhin and Schulze (2009) discuss that corruption increases uncertainty in government institutions and the business climate which hampers firm innovation Hence, it would be useful to examine how the quality of institutions affects the returns to innovation

This paper will focus on establishing additional evidence that supports the positive correlation of firm’s product innovation with the country’s institutional quality This result would suggest that poor institutional quality leads to lower returns to innovation, and therefore discourages firms to innovate their products The covered countries in this paper are the Southeast Asian countries with available data on innovation-related questions on the WBES The table below summarizes the countries and the number of firms in the 2009 and 2015 datasets

Table 1 List of countries

Source: Author calculations from WBES

The table above shows that Viet Nam has the most number of firms in the dataset while the Philippines has the least number of firms having around 27% of the total sample To further describe the dataset, Figure 1 shows a summary of how many firms produced new and improved products based on the 2015 survey Based on the figure below, Indonesia has the most number of firms that did not innovate during 2015 while the Philippines have the most number of firms that introduced innovation in their products in 2015 Furthermore, there are more small firms than medium and large firms in the sample Figure 1 also shows that large firms tend to innovate more

than the small and medium firms On the other hand, the small firms tend to innovate least out of the three firm size classifications

This paper is organized as follows: Section one is the introduction to the study while the second section is the review of literature The data, empirical methodology, and results will be discussed

in Sections three and four Section five tackles the conclusions and recommendations

Figure 1 Firms’ Innovation in Indonesia, Philippines and Viet Nam

(Number of observations)

Source: Author calculations from WBES

2 Review of Related Literature

The empirical evidence on the impact of innovation, given a better institutional quality, on firm performance in Asian economies has been limited Nevertheless, there is a consensus that better institutional quality incentivizes firms to innovate which then positively affects firm sales This has been established using empirical evidence in the Latin Americas, Caribbean, Europe, Central Asia, and South African regions

Estimating the returns to innovation is already widely studied in the literature such as studies by Van Reene (1997) for the UK, Greenan and Guellec (2001) for France, Hall et al (2008) for

261

336

319

156

465

295

1028

918

700

1134

841

671

0 200 400 600 800 1000 1200 1400 Small

Medium

Large

Indonesia

Philippines

Viet Nam

Innovate Do not innovate

Italy, Guadalupe et al (2012) for Spain The aforementioned studies focused on the manufacturing sector in developed countries On the other hand, studies by Benavente and Lauterbach (2008) for Chile, Aboal et al (2011) for Uruguay, and Crespi and Tacsir (2012) for four Latin American countries aimed to quantify the returns to innovation of developed countries

in the said countries

On the other hand, studies that explore the relationship of innovation, institutional quality, and economic growth can either be examined on a macro or micro level Some of the macro level studies that look into the relationship between innovation and institutional quality include Tebaldi et al (2013), Oluwatobi et al (2014), Kocak (2017), Bekhet et al (2018), and Donges et

al (2016) Tebaldi et al (2013) use a cross-country dataset and instrumental variable method They found that control of corruption, market-friendly policies, protection of property rights and

a more effective judiciary system boost a country’s rate of innovation Oluwatobi et al (2014) use a sample of African countries over the period 1996-2012 and implemented the system generalised method of moments (SGMM) estimation technique to establish that government effectiveness and regulatory quality advance the rate of innovation Kocak (2017) used a similar technique on a sample of developing countries over the period 1997-2014 to support Oluwatobi

et al (2014) that institutional quality indicators such as bureaucratic quality, government stability, democratic accountability and law and order have a positive relationship with innovation Bekhet et al (2018) utilize an augmented production function, F-bound, dynamic ordinary least squares, and Granger causality tests to investigate that the interaction between technological innovation and governance institution quality has a significant positive impact on Malaysia's economy in the long run using 1985-2015 data Lastly, Donges et al (2016) find that German counties whose institutions are more inclusive as a result of the French occupation become more innovative In addition, their results are relevant in understanding the channel by which institutions may have affected economic growth

Various studies in the literature also considered looking at the relationship of institutions, innovation, and firm performance on a micro level The related literature include studies by Barasa et al (2014), Goedhuys et al (2016), Yang (2016), Nguyen and Jaramillo (2014), and Nguyen and Jaramillo (2016) Barasa et al (2014) utilize the firm-level data from the WBES and

the Innovation Follow-up Survey for the years 2010 through 2012 The results of their multilevel logistic model conclude that strengthening the institutional environment within which businesses operate promotes entrepreneurial activities and ultimately innovation at the firm level Goedhuys

et al (2016) use firm-level data from Egypt and Tunisia and conditional recursive mixed-process model (CMP) to show that corruption has a negative effect on the likelihood that a firm is an innovator On the other hand, innovation has a positive and significant effect on firm growth Yang (2016) establishes that SME innovators tend to have higher sales and profits when courts are perceived to be strong using data from the Latin America and Caribbean Nguyen and Jaramillo (2014) also use WBES data collected in the Latin America, Europe, and Central Asia and find that poor institutional environment lowers firms’ return to innovation Nguyen and Jaramillo (2016) strengthen the findings by using WBES data focused on the Latin American countries Based on their paper, firms have greater incentives to innovate in countries with better institutional quality, and the returns to innovation are higher in countries with good property rights and patent rights protection

Given the limited number of studies using Asian data on a firm-level analysis, this paper aims to fill in the gap by estimating a simple OLS model with fixed effects to examine how the quality of institutions affect the firm’s decision to innovate that is essential in its firm growth

3 Data and empirical methodology

The firm-level data comes from the 2009 and 2015 WBES for Indonesia, the Philippines, and Viet Nam The respondents are firms in the non-agricultural formal private economy particularly from the manufacturing, services, and transportation and construction sectors The said firms answered a common survey questionnaire across all countries that focus on finding out what factors accommodate or constraint the business environment including the innovation-related factor which is the main interest in this study The paper employs the question, “New or significantly improved product introduced in last three years?”, on innovation

This measure of impact of innovation in the WBES for most countries is limited and is only available in the 2015 survey Based on this question, a dummy variable was constructed and will

be explained in detail in the model specification

To estimate the effect of innovation and institutional quality on firm sales in 3 ASEAN countries,

an equation, largely based on a Latin American, European, and Central Asian study by Nguyen and Jaramillo (2014), will be used The OLS equation has been modified as follows1:

(1)

(2)

where are the log of annual total sales and log of annual total sales per worker of firm in country ; is a dummy variable equal to 1 if firm in country innovates between 2009 and 2015; is a vector of firm characteristics such as firm sector, firm size, firm age, changing of manager, and dummy variables of whether the firm exports or not and whether the firm is state-owned or not; and are country and time fixed effects; and is a random error term The equation uses two variables for institutional quality: , and The dataset from the World Bank’s World Governance Indicators (WGI) summarizes the views on the quality of governance taken from a large number of enterprise, citizen and expert survey respondents in over 200 industrial and developing economies from

1996 to 2017 In addition, the six aggregate dimensions of governance are gathered by the World Bank from a number of survey institutes, think tanks, non-governmental organizations, international organizations, and private sector firms For all the three indicators in this paper, the estimate of governance (ranges from approximately -2.5 (weak) to 2.5 (strong) governance performance), was used.The first indicator, regulatory quality, reflects perceptions of the ability

of the government to formulate and implement sound policies and regulations that permit and promote private sector development On the other hand, the second indicator, voice and accountability, reflects perceptions of the extent to which a country's citizens are able to participate in selecting their government, as well as freedom of expression, freedom of association, and a free media

The expected sign of is positive which would indicate that innovation has a direct relationship with firm sales There are several mechanisms that explain why innovation has a positive effect

on firm performance A new product may complement the old product while an improved

1 Baseline regressions, excluding the institutional quality indicators, were also estimated

product may drive out the old product Hence, a successful introduction of a new or an improved product in the market is expected to increase sales The control variables included in the study are firm-specific characteristics that are said to have an effect on the firm performance or firm sales based on the literature

4 Results

The results at country level (Table 2) show that firm-specific characteristics such as sector, size, and exporting dummy are consistent and robust determinants of firm sales These variables are positive and significant using the baseline analysis using OLS estimation technique Thus, having a large size improves firm performance On the other hand, being an exporter yields higher sales to the firms as well Wider market coverage, allowing penetration to external markets, suggests a positive effect on firm performance

Table 2 Return to Innovation

Dependent

variable

Log of sales Log of sales per

worker

Log of sales Log of sales per

worker Country

dummies

Firm Size (Small

5-19)

Medium

(20-99)

Large (>=100)

1.551***

(0.077) 3.242***

(0.091)

0.445***

(0.067) 0.757***

(0.078)

1.550***

(0.077) 3.239***

(0.091)

0.444***

(0.067) 0.754***

(0.078) Firm Sector

(Manufacturing)

Garments

Textiles

Chemicals

Rubber and

Plastics

Nonmetallic

Mineral Products

Other

Manufacturing

Retail services

Other services

-0.699***

(0.136) 0.224 (0.141) 0.301**

(0.139) 0.135 (0.138)

0.362**

(0.149)

0.159 (0.143)

0.352**

(0.181) 0.032 (0.162)

-0.739***

(0.118) 0.131 (0.122) 0.240**

(0.120) 0.089 (0.121)

0.398***

(0.131)

0.240**

(0.124)

0.623***

(0.166) 0.211 (0.143)

-0.707***

(0.136) 0.223 (0.141) 0.305**

(0.139) 0.141 (0.137)

0.368***

(0.149)

0.155 (0.143)

0.356**

(0.180) 0.034 (0.163)

-0.747*** (0.118) 0.129 (0.122) 0.244** (0.120) 0.092 (0.121)

0.401*** (0.131)

0.238** (0.123)

0.627*** (0.166) 0.214 (0.143)

(0.0002)

0.0003 (0.0002)

0.0003 (0.0002)

0.0003 (0.0002) Firm is owned by

the state

0.587*

(0.327)

0.070 (0.275)

0.632**

(0.324)

0.104 (0.270) Firm is an

exporter

0.961***

(0.099)

0.421***

(0.085)

0.951***

(0.098)

0.410*** (0.085) Changing

manager

0.347*

(0.197)

0.293*

(0.174)

0.333*

(0.196)

0.280 (0.173) Innovation 0.925***

(0.122)

0.769***

(0.106)

0.774***

(0.097)

0.567*** (0.084) Regulatory

Quality times

1.541***

(0.365)

1.804***

(0.311)

Innovation

dummy

Voice and

Accountability

times Innovation

dummy

0.570***

(0.104)

0.595***

(0.089)

(0.222)

17.591***

(0.197)

Robust standard errors in parenthesis

***p<0.01, ***p<0.05, ***p<0.1

Source: Author’s own calculations using Stata 15

In terms of the variables of interest in this study, the results (Table 2) show that innovation has a positive and significant relationship to firm sales These results are consistent and robust across all model specifications Thus, the results suggest that if the firm has a new product or improved its product in the market, its firm performance increases The interaction variables of indicators

of institutional quality and innovation dummy variable capture the impact of the firm’s innovation on firm sales conditional on the better institutional quality measures This will help determine whether better institutional quality encourages firms to innovate that positively affect firm performance The results show that the two interaction variables have a positive and significant effect on firm performance This means that better institutional quality is essential in enhancing firm innovation that increases firm sales Hence, firms should deem better institutional quality necessary and view it as an incentive to innovate In addition, innovation when there is better regulatory quality is higher compared to innovation not taking into consideration an indicator for institutional quality This effect is given by the positive, significant, and higher coefficient of the interaction variable, regulatory quality times innovation dummy However, no matter how robust the results are from different model specifications, simultaneity problem is not

accounted for in these models as the data limitations made it difficult to minimize the problem brought by endogeneity issues

5 Conclusions and recommendations

The results in this study have shown that firm innovation, whether producing a new or improved product, has a positive and significant impact on firm sales This finding appears to be robust across all model specifications that were used in this paper using the OLS estimation technique Furthermore, the findings reveal that countries with higher institutional quality tend to have higher returns to innovation Thus, better institutional quality incentivizes the firms to innovate more as poor institutional quality hampers firms from researching and developing new and improved products In addition, larger firms and being an exporter increases firm performance Given these results, the governments must encourage and make programs for the small and medium firms to innovate to help these firms increase their sales Moreover, the governments should give support to non-exporting firms to export if they have the resources to do so given that being an exporter positively affects sales Finally, the governments must strengthen their institutional governance for a better business climate

References:

Aboal, D., Garda, P., Lanzilotta, B., and Perera, M (2011) “Innovation, Firm Size, Technology

Intensity, and Employment Generation in Uruguay The Microeconometric Evidence.” IDB Technical Notes No IDB-TN-314 Washington, DC: IDB

Anokhin, S., & Schulze, W S (2009) Entrepreneurship, innovation, and corruption Journal of

Business Venturing, 24(5), 465-476

Barasa, L., Kimuyu, P., Vermeulen, P A M., Knoben, J., & Kinyanjui, B (2014) Institutions,

Resources and Innovation in Developng Countries: A Firm Level Approach (DFID Working Paper) Tilburg: Tilburg University