European Economic Review 44 (2000) 748}761
Business groups and social welfare in
emerging markets: Existing evidence and
unanswered questions
Tarun Khanna*
Harvard Business School, Morgan Hall 221, Soldiers Field Park, Boston, MA 02163, USA
Abstract
This paper reviews existing studies of the role of emerging market business groups,
a ubiquitous but poorly understood organizational form. I "rst suggest that understand-
ing the de"nition of business groups is itself an interesting, albeit under-studied, research
issue. I then argue that the existing evidence suggests that the performance e!ects of
group a$liation are large and generally positive. There is substantial evidence that part
of this is due to welfare-enhancing functions originating in the idea that groups substitute
for missing outside institutions, but that part is also due to welfare-reducing minority
shareholder exploitation. Evidence is lacking on the extent to which groups facilitate
rent-seeking or the exercise of market power. Evidence is also lacking on the extent to
which groups hamper the future development of markets. The paper identi"es areas
where research is needed before current competition policy experiments in countries like
China, India and Korea can be evaluated. 2000 Elsevier Science B.V. All rights
reserved.
JEL classixcation: G30; L20; L40; P5
Keywords: Business groups; Emerging markets; Competition policy
* Tel.: #[phone]; fax: #[phone].
E-mail address: [e-mail] (T. Khanna)
0014-2921/00/$ - see front matter 2000 Elsevier Science B.V. All rights reserved.
PII: S 0 0 1 4 - 2 9 2 1 ( 9 9 ) 0 0 0 5 9 - 8
T. Khanna / European Economic Review 44 (2000) 748}761 749
1. Introduction
Diversi"ed business groups dominate the economies of most countries
(Granovetter, 1994; Khanna and Palepu, 1997). In this paper, I review theoret-
ical and empirical work regarding business groups with a view to identifying
what these studies say about the welfare consequences of group a$liation.
After discussing multiple de"nitions of the term &group' (Section 2), I consider
in turn the static e!ects (Section 3) and dynamic e!ects (Section 4) of group
a$liation. The fact that I draw primarily on evidence from studies set in
Asia and Latin America should not be seen as re#ecting anything other than my
relative lack of knowledge of studies set elsewhere. I occasionally refer to a
vast literature on Japanese keiretsu whenever doing so draws attention to un-
resolved issues, even though Japan is not usually thought of as an emerging
market.
2. What is a group?
A "rst step in the study of the e!ects of group a$liation is the de"nition of
groups. Yet this is a non-trivial task. Le! (1978, p. 663) refers to a business group
as &a group of companies that does business in di!erent markets under a com-
mon administrative or "nancial control' and says that its members are &linked by
relations of interpersonal trust, on the basis of a similar personal, ethnic or
commercial background'. Other de"nitions by academics and regulators sim-
ilarly emphasize both formal and informal social and economic ties among
group a$liates.
Economists who have studied business groups have tended to emphasize that
group a$liates are linked together through equity cross-ownership patterns.
For example, Wolfenzon's (1999) theoretical model starts with an assertion that
groups usually take a pyramidal form, where a pyramid is de"ned as a hierarchi-
cal chain of ownership relations. Such equity pyramids are also emphasized by
European scholars (Nicodano, 1998; Van Hulle, 1998). Flath (1992) sees
Japanese keiretsus as an e$cient mechanism through which indirect equity
interlocks can be created among a collection of "rms.
Sociologists, political scientists and historians tend, on the other hand, to
emphasize a medley of formal and informal relationships that link together
group a$liates (Granovetter, 1994). Indeed, several recent studies cast doubt on
economists' equation of groups and pyramids. A study of Chilean groups by
Khanna and Rivkin (1999a) demonstrates that equity interlocks, both direct and
indirect, explain only a small fraction of group membership. Further the study
shows that the returns of group a$liates covary even after the portion of the
covariation due to equity cross-holdings is stripped away, suggesting that there
is more to group membership than equity cross-holdings. The results of other
750 T. Khanna / European Economic Review 44 (2000) 748}761
econometric studies can be interpreted similarly. School ties appear important
in explaining group membership in China (Keister, 1998a), and interlocking
directorates do so in Hong Kong (Wong, 1996). Gerlach (1992) demonstrates
that equity ownership, bank relationships and director interlocks collectively
only imperfectly explain membership in Japanese keiretsu. Thus, I tentatively
conclude that empirical support for the idea that group membership is driven
primarily by equity interlocks is suspect. Since existing theoretical work only
models groups as collections of "rms held together by equity interlocks, it seems
fair to say that we are far from having a good theory of business groups.
From a practical standpoint, there are several points that ambiguity in group
de"nition make worth noting. First, though I review both within-country and
cross-country results below, the former are more reliable than the latter since
group de"nition varies quite substantially across countries. Second, some with-
in-country results are more reliable than others because there is greater consen-
sus about group de"nition in some countries, as in India (Khanna and Palepu,
1999a,b), than in others, as in Central America (Strachan, 1976). Third, part of
the de"nitional imprecision has to do with the fact that there are varying degrees
to which the interests of a particular "rm are subordinated to the interest of the
group to which it belongs. Thus, the degree of &tightness' of control varies across
countries (being quite lax in some countries like Japan and Taiwan, and quite
tight in others like Indonesia), and also among groups within a country.
Empirical work must account for the fact that the degree of central control is
virtually never an observable for the econometrician. Fourth, despite the impre-
cision with which groups might be measured, group membership does explain
a substantial part of "rm performance in a range of countries (Khanna and
Rivkin, 1999b).
3. Static e4ects
In this section, I "rst review econometric evidence on the performance e!ects
of group a$liation, and then discuss multiple interpretations of this evidence.
3.1. The performance ewects of group azliation
Khanna and Rivkin (1999b) study the e!ects of group a$liation on a measure
of pro"tability (operating returns/assets) in 14 emerging markets in Asia, Latin
Marriage brings together families, and with them, their groups. Inter-group joint ventures also
blur boundaries. It is noteworthy that the di$culty of de"ning groups in Japan (Saxonhouse, 1993;
Weinstein and Yafeh, 1995) has not deterred the development of a huge empirical literature on
Japanese keiretsu.
T. Khanna / European Economic Review 44 (2000) 748}761 751
America and South Africa. In a series of within-country estimations, they
estimate speci"cations which allow for a series of "xed e!ects for group member-
ship (with controls for "rm and industry "xed e!ects). They "nd that the mean of
the estimated group e!ects is statistically signi"cantly positive in four countries
and statistically signi"cantly negative in only one country. Additionally, in 13 of
their 14 countries, group membership explains a statistically signi"cant amount
of variation in their pro"tability measure, with the group e!ects collectively
explaining more of the variation than industry e!ects in many countries. In
contrast to this study, most empirical studies are focused on group a$liation in
a single country. Keister (1998b) shows that the formation of groups in China
improved "nancial performance and productivity in the late 1980s, and that
more centralized groups did better than others. Perotti and Gelfer (1999) "nd
that group "rms in Russia have higher values of Tobin's q than otherwise
comparable una$liated "rms.
The performance e!ects of group a$liation may also depend upon group
covariates, especially group size and group diversi"cation. Chang and
Choi (1988) show that a$liates of the largest four Korean chaebol outperform
all other "rms, including a$liates of smaller chaebol and una$liated "rms.
Khanna and Palepu (1999a) use data on Indian groups to document a
curvilinear relationship between "rm performance, measured using both
ROA or Tobin's q, and group diversi"cation. Marginal increases in group
diversi"cation beyond a certain threshold, but not before it, result in marginal
improvements in "rm performance. A$liates of the most diversi"ed groups
have higher values of Tobin's q than all other "rms in the economy. Similar
results can be found for Chile (Khanna and Palepu, 1999c), though, unlike
the Indian case, the estimations also reveal a simultaneous non-diversi"cation
related performance e!ect of group a$liation in this country. While not directly
comparable, this curvilinear relationship is in stark contrast to results using
US data which suggest that membership in a diversi"ed conglomerate
destroys value (Berger and Ofek, 1995; Lang and Stulz, 1994; Montgomery,
1994).
The low returns of keiretsu a$liates contrast with some of these emerging
market "ndings. Empirical studies by Caves and Uekusa (1976) and Nakatani
(1984), and theoretical work by Aoki (1984), suggest that keiretsus perform
a mutual insurance function, which results in their sacri"cing returns for lower
risk. Others suggest that the low returns of keiretsu a$liates may imply that
they capture less of the value created by bank}"rm ties, since banks hold more of
the bargaining power (Cable and Yasuki, 1985; Weinstein and Yafeh, 1995,
1998). Under both interpretations, the lower pro"tability of keiretsu a$liates is
not related to intrinsic ine$ciency of keiretsus. Beyond Japan, one study which
addresses the oft-cited idea of risk reduction constituting the raison d'e( tre for
business groups "nds that the inter-temporal variance of pro"tability (as mea-
sured by operating returns/assets) is indeed lower for group a$liates than for
752 T. Khanna / European Economic Review 44 (2000) 748}761
non-groups, though only in half the sample of 10 emerging markets (Khanna
and Yafeh, 1999).
There are several issues with the econometric work which relates "rm perfor-
mance to group a$liation.
(i) First, all these studies are based on publicly traded "rms. It is commonly
known that most major business groups have a large number of unlisted
entities. Anecdotal observations suggest that listing criteria vary across
countries, though the di$culty of getting data on unlisted companies has
meant that there are no studies of the circumstances under which groups
chose to list subsidiaries. As such, the direction of such bias as might exist in
the performance}a$liation regressions is unclear.
(ii) Second, some econometric issues deserve to be noted regarding the regres-
sions in most of the above studies. Common unobserved factors might cause
both group a$liation and "rm performance, making inferences regarding
causality somewhat problematic. Reverse causality might be a problem,
with pro"table (or unpro"table) companies joining groups rather than the
reverse. More generally, reliable instruments for group membership, of the
sort that a!ect a "rm's decision to join a group but do not a!ect its
performance, have proven di$cult to identify .
(iii) Third, it is unclear which performance measure is the best, and studies
vary in the emphasis that they place on one or more measures. ROA
su!ers from business cycle e!ects, does not consider di!erences in system-
atic risk, and is not forward looking (Benston, 1985). Tobin's q mitigates
these problems but makes the problematic assumption, given the illiquidity
and untimely disclosure problems of capital markets in most emerging
markets, that stock prices appropriately re#ect the bene"ts and costs of
diversi"cation. Finding a solution to this issue is itself a topic worthy of
research.
Despite these issues, a tentative conclusion is that "rms bene"t from group
a$liation for the most part. I sequentially review four classes of possible
explanations.
3.1.1. Ezciency enhancing functions
Ever since Nathaniel Le!'s (1976,1978) early work, economists have sugges-
ted that groups might enhance social welfare by alleviating market imper-
fections. Chang and Hong (1999) "nd evidence that Korean chaebol run
I note two promising ways forward. First, groups often form along ethnic or familial lines. If such
characteristics are reasonably taken to be orthogonal to performance, then amassing data on "rms'
ethnic or familial origin, may help resolve some of these issues. Second, revisiting the process by
which groups formed historically might prove useful, as Yafeh (1995) does for Japan.
T. Khanna / European Economic Review 44 (2000) 748}761 753
value-enhancing internal product and (managerial) labor markets. Perotti and
Gelfer (1999) "nd evidence that Russian Financial Industrial Groups (FIGS)
allocate capital more e$ciently among their a$liates than does the external
market. Khanna and Palepu (1999b) "nd that indices of product, labor and
capital market intermediation, constructed from "eld-collected data for each of
nine Chilean and nine Indian business groups, are positively correlated with
both accounting and stock market measures of performance.
An especially large amount of work has concentrated on capital market
intermediation by groups. But there is little a priori reason to believe that it is
capital market imperfections that are especially prone to being resolved by
groups. Indeed, groups in many countries do not have group-speci"c "nancial
institutions like the keiretsu's main bank and have legal restrictions in place on
internal capital market activity (even if these are only imperfectly enforced).
Khanna and Rivkin's (1999b) cross-country study "nds that indicators of capital
market imperfection are not correlated with indicators of the performance
implications of group a$liation (as de"ned earlier). Khanna and Palepu (1999a)
"nd that, unlike the results for Japanese keiretsu, proxies for "rm investment are
no more correlated with "rm cash-#ow for Indian group a$liates than for
una$liated "rms, suggesting that group a$liates do not rely on internal capital
markets any di!erently than una$liated "rms.
Two other manifestations of the group's role as intermediary deserve
mention. First, the intermediary institutions that facilitate the functioning of
markets are particularly under-developed in some regions within emerging
markets. Anecdotal evidence exists of groups fostering development by rotat-
ing management talent from existing operations (in urban areas) to under-
developed regions, and by channeling capital obtained from urban
"nancial institutions to such regions. Fisman and Khanna (1998a) show
that group a$liation increases the likelihood of locating plants in exceed-
ingly under-developed regions in India in a way that is not only value-
enhancing for shareholders, but is more e$cient than state-led attempts
to develop such regions. Second, and in quite a di!erent vein, groups can
serve as intermediaries in cross-border markets for capital and
technology transfer. Fisman and Khanna (1998b) demonstrate that group
a$liation facilitates the issuance of global depositary receipts by Indian
"rms.
Roughly a decade ago, Caves (1989, p. 1226) said in his survey, &Thanks to its
successes, modern analytical economics is treated by its practitioners as institu-
tion-free, exposing the consequences of fundamental human motives and tech-
nological opportunities unclouded by any detritus of law, culture, language,
custom or history. Institutions cannot be dismissed with a wave of the hand:
they would not emerge, were they not e$cient. Yet this transparency of the
institutional context of economic behavior is an assumption, not a tested
hypothesis'. If there is a single common theme in the papers reviewed in this
754 T. Khanna / European Economic Review 44 (2000) 748}761
section, it is that institutions do matter in shaping economic outcomes. It is
perhaps sensible to see groups acting as substitutes for missing institutions,
which would normally facilitate the functioning of markets, in the economy
(Khanna and Palepu, 1997,1999a}c). Such a view would also accommodate the
notion that groups substitute for di!erent missing institutions in di!erent
economies.
3.1.2. Minority shareholder exploitation
A substantial body of theoretical work suggests that groups serve as a device
through which minority shareholders can be expropriated. Pyramidal
ownership structures o!er one mechanism through which this might happen
(Wolfenzon, 1999). A commonly cited reason for pyramiding is to allow an
entrepreneur to control "rms with minimal equity, in a manner exceeding that
possible through the issuance of dual class shares (Bebchuk et al., 1999).
Controllers of pyramids may ply their trade with impunity partly because
pyramiding makes it harder for the market to discipline them through the
takeover mechanism (Sheard, 1991; Ghemawat and Khanna, 1998). The ubi-
quity of pyramids in 27 wealthy countries has recently been established by La
Porta et al. (1999).
Empirical evidence on minority shareholder expropriation through pyr-
amiding is accumulating. Claessens et al. (1999) construct a measure of separ-
ation of cash #ow to voting rights for a sample of East Asian pyramids and "nd
that this measure is associated with a reduction in Tobin's q. Johnson et al.
(1999) show that stock market measures declined more during the recent Asian
"nancial crisis in countries with poor minority shareholder protection, and
interpret this result as suggesting that there was an upsurge of managerial
stealing in poor economic times. Khanna and Palepu (1999d) "nd that foreign
institutional investors in India, who they argue serve a valuable monitoring
function, were more likely to invest in una$liated "rms and in group "rms
which were more transparent than in less transparent groups. In their study,
greater transparency is proxied for by a lower incidence of intra-group "nancial
transactions. Finally, in an advanced economy context, Morck et al. (1998) show
that Canadian pyramids are associated with lower growth.
But some counter evidence also exists. A divergence between the Tobin's
q and ROA results in the performance-group a$liation regressions
reviewed above would suggest that even though "rms are e$cient at a
point in time, external shareholders fear that the gains will not accrue to
them, and hence discount the value of the "rm. However, for at least
More generally, lack of protection for minority shareholder rights has been argued to impede the
e$cient functioning of "nancial markets (La Porta et al., 1998). The resultant ine$ciencies in capital
markets can prevent the entry of de novo entrepreneurs and thus sti#e competition.
T. Khanna / European Economic Review 44 (2000) 748}761 755
two countries, Chile and India (Khanna and Palepu, 1999a,c), the results are
qualitatively similar using both performance measures. The interpretation that
a substantial part of the gains from group a$liation accrue to minority share-
holders is inconsistent with the strong version of the minority shareholder
expropriation story.
Chang et al. (1999) take seriously the idea that, if minority shareholder
expropriation is easier to accomplish away from the glare of outside scrutiny,
and if groups are the engines through which such expropriation occurs, it
should be the case that groups are harder to monitor. While they "nd that,
conditional on being followed by analysts, forecasts for group a$liates are
indeed less accurate than for una$liated "rms, the magnitude of the group e!ect
is small. Further, groups appear more likely to be followed, and country
level factors (such as overall accounting infrastructure) a!ect aggregate analyst
activity more than does overall presence of groups. It may be that groups
are harder to monitor, causing the supply curve for analyst activity to shift
inward, but this may be o!set by the demand curve for analyst activity
shifting out, rendering overall e!ects of group a$liation on transparency
ambiguous.
3.1.3. Rent-seeking
Groups might be socially counterproductive because they serve as a mecha-
nism through which a handful of "rms obtain favorable treatment from the
power structure of the country in question, thus posing a direct barrier to the
operation of competitive forces in allocating resources e$ciently in the econ-
omy. Further, close connections to the power structure of the controlling
families ensures that they can be bailed out in times of distress, especially since
they are often considered &too big to fail'.
While oft-asserted as the raison d'e( tre for groups, systematic empirical evid-
ence is hard to come by. Perhaps the most direct support of the rent-seeking
hypothesis is provided by Fisman's (1998) event study in Suharto's Indonesia.
He "nds that surprise announcements related to Suharto's mortality yield sharp
reductions in the market capitalization of "rms that are positively correlated
with an independently derived measure of proximity to the President or to his
family or inner circle. The suggestion is that much of the market value of groups
is related to closeness to the power structure.
Chile o!ers an interesting contrast, since cross-country survey-based index
compilations suggest that there is very little corruption there. The strong
positive performance e!ects of group a$liation in Chile appear inconsistent
with the idea that groups are purely rent-seeking devices. Further, Khanna and
Rivkin's (1999b) cross-country analysis "nds no correlation between country
level corruption indices and measures of the performance e!ects of group
a$liation across a sample of emerging markets.
756 T. Khanna / European Economic Review 44 (2000) 748}761
3.1.4. Market power
I am unaware of tests that speak directly to the issue of groups exercising
market power (unrelated to the mechanisms in 3.1.1}3.1.3 above) in emerging
markets. The anecdotal evidence suggests that business groups are not
mechanisms through which cartelization proceeds, nor ways of facilitating
multimarket contact to enhance collusion. Entry deterrence is considered in the
subsequent section on dynamic e!ects of the presence of groups on industry
structure.
Group a$liates are typically spread across multiple, and quite diverse, indus-
tries, a mechanism which has been referred to as the &complete-set principle' in
the keiretsu literature (Flath, 1994). Cartelization does not appear to operate,
consistent with Encaoua and Jacquemin's (1982) early results from French
groups. Especially given such a one-set principle, one might suspect that there is
ample room for market power through multimarket collusion (Bernheim and
Whinston, 1990). However, such collusion is unlikely to be a "rst-order phenom-
enon. Keiretsu members appear to compete quite "ercely, goaded on by banks
(Weinstein and Yafeh, 1995), and chaebol a$liates are kept honest by overseas
competitors in global markets.
A tentative summary of the underlying causes of the performance e!ects of
group a$liation is perhaps in order. There is substantial evidence of minority
shareholder exploitation, but also of actions that are welfare enhancing. It is
plausible that countries di!er in the extent to which the groups are responses to
one or the other form of behavior, with Chile, with its low levels of corruption,
being my favorite example of &groups as paragons' and Indonesia, with
patronage politics instituted under Suharto, being my favorite example of
&groups as parasites'. It is also possible that groups within a country vary in their
extent of e$ciency-enhancing versus other modes of operation. Much research
is needed to resolve these issues. What seems clear is that an extreme character-
ization of groups as purely socially harmful or purely socially welfare enhancing
appears unsupported by the evidence. It is especially premature to conclude
anything about ways in which market power may or may not be exercised by
groups.
4. Dynamic e4ects
There are three ideas that I explore in this section, albeit brie#y since there is
substantially less relevant work to discuss. First, do groups prevent entry and
Ghemawat and Khanna (1998) o!er a research methodology, capitalizing on unexpected rapid
changes in dozens of countries' &openness' to outside competition, to sort through competing
explanations for the existence of groups.
T. Khanna / European Economic Review 44 (2000) 748}761 757
thus explicitly a!ect future industry structure? Even absent explicit in#uences,
what e!ect does the mere existence of groups have on future industry structure?
What does the evidence suggest about the long run persistence (or lack thereof)
of groups?
Contrasting interpretations #ourish regarding whether or not Japanese
keiretsu deter entry (Lawrence, 1991; Saxonhouse, 1993). Elsewhere, a common
means by which groups in many emerging markets are alleged to keep out
foreign in#uence is through lobbying the government to impose tari! or non-
tari! barriers on imports and to prevent entry by multinationals. There is no
direct evidence of which I am aware on this front, and even the anecdotal
evidence is not clear cut.
The most direct way through which groups might keep out domestic competi-
tors is through obtaining preferential access to permits and licenses and impli-
citly denying these to de novo entrants. The hypothesized microeconomic
mechanism underlying this preferential treatment is that groups, given their
broader scope and scale, are in a position to use multi-use favors more e!ec-
tively, and are thus likelier to (implicitly) bid higher values for such favors. There
are other mechanisms which are anecdotally discussed in various countries as in
India (Paranjpe, 1988, p. 2343) and Thailand (Tara Siam Business Information
Limited, 1997, p. 2).
The mere existence of groups might hamper the development of markets.
Consider "nancial markets. Suppose groups are less transparent and fairly
dominant in the economy. Since groups rely on internal sources of "nancing
and are less likely than una$liated "rms to seek external capital, the demand
for analyst services might be attenuated. Further, analysts might "nd it
di$cult to evaluate groups. The lack of entry of this critical information
intermediary might make it harder for vibrant capital markets to emerge.
Thus, groups bene"t their members but at a social cost. In a related vein, Kali
(1999a) models the manner in which existing groups might hamper market
development.
Finally, I review some evidence on the longevity of groups. How long do groups
last when there is no explicit attempt to dismantle them? Chile, the site of
a long-lasting concerted move toward free markets in the post-Allende (post-1973)
period, o!ers an interesting data point. The performance e!ects of group a$liation
have atrophied, consistent with the implications of the development of well-
functioning markets, but have done so quite slowly (Khanna and Palepu, 1999c).
Related to this is the issue of whether the opening up of countries around the world
to external competition will accelerate the demise of groups. In a study of nine of the
largest groups in each of Chile (1987}1997) and India (1990}1997), Khanna and
Palepu (1999b) found quite the converse. The groups in both countries expanded
their scope, strengthened their attempts at internal intermediation and improved
their performance relative to una$liated "rms, at a time when distortions in the
economy were reducing and markets developing rapidly. Kali's (1999b) model of the
758 T. Khanna / European Economic Review 44 (2000) 748}761
choice between risk-sharing through the stock market versus through business
groups is consistent with their results in that an outcome of his model is a period
during which both market development occurs and business groups strengthen.
These studies cast doubt on the idea that groups are not long-lived.
5. Conclusion
Group a$liation is simultaneously welfare enhancing, since groups can be
responses to market failures, and welfare reducing, since groups can be used to
exploit minority shareholders. Evidence is sorely needed on the extent to which
groups facilitate rent-seeking or the exercise of market power, and on the extent
to which the existence of groups hampers the future development of markets.
Until such evidence is accumulated, it is di$cult to evaluate the range of policy
experiments currently underway } from building groups in China, to benign
neglect in India, to dismantling them in Korea (Khanna and Palepu, 1999e).
Conventional approaches to competition policy, emphasizing activist regulation
of "rms to varying degrees (Jacquemin and Slade, 1989), are unlikely to help. In
emerging markets, it may be that focusing on building the institutions that
reduce market failures may be the "rst-order issue, rather than regulating "rm
behavior which may be seen as a response to existing market failures.
Acknowledgements
I am grateful to Richard Caves, Raymond Fisman, Fritz Foley, Raja Kali, Jan
Rivkin, Yishay Yafeh, and to a seminar audience at the 1999 European Eco-
nomic Association Meetings session on &Competition Policy and Development',
Santiago de Compostela (Spain), for helpful comments.
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