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National Culture and Profit

Reinvestment: Evidence from Small

and Medium-Sized Enterprises

Sadok El Ghoul, Omrane Guedhami, Chuck Kwok, and Liang Shao∗

We examine the role of national culture—an important informal institution—in the profit rein-

vestment decisions of small firms in emerging markets. Prior economic development literature

focuses on formal institutions as determinants of growth. However, in emerging markets where

formal institutions are less developed, informal institutions should have more of a direct versus

indirect impact through formal institutions. We find that Schwartz’s cultural dimensions of Embed-

dedness and Hierarchy negatively affect profit reinvestment, and that access to external financing (strength of property rights) is more important for reinvestment decisions in countries with low

(high) Embeddedness and Hierarchy.

What factors contribute to economic development? Prior research points to two formal insti-

tutions: strength of property rights (e.g., Mauro, 1995; Svensson, 1998; Claessens and Laeven,

2003) and access to external financing (e.g., Levine, 1997; Rajan and Zingales, 1998; Levine,

Loayza, and Beck, 2000). Country-level data cannot shed light on which of these institutions

is more important for economic growth because they are highly correlated. Recent research

therefore relies on micro data to disentangle the effects of property rights and external finance,

examining their relative importance in explaining firms’ profit reinvestment decisions. Johnson,McMillan, and Woodruff (2002), for instance, demonstrate that weak property rights are the

central impediment to profit reinvestment in five postcommunist countries (Poland, Slovakia,

Romania, Russia, and Ukraine). In contrast, Cull and Xu (2005) find for a sample of firms from

China that access to external financing is an equally important predictor of profit reinvestment,

suggesting that the importance of market-supporting (financial) institutions depends on the level

of development of a country’s economy (McMillan and Woodruff, 2002).1 Extending the above

line of research, in this paper, we examine the relation between an important informal institution—

national culture—and profit reinvestment by small f irms in emerging markets and we investigate

whether culture affects the relative importance of formal institutions for profit reinvestment

decisions.

We thank an anonymous reviewer, Najah Attig, Narjess Boubakri, Raghavendra Rau (Editor), and Xiaolan Zheng

for constructive comments. We appreciate generous financial support from Canada’s Social Sciences and Humanities

Research Council.

∗Sadok El Ghoul is an Associate Professor at the University of Alberta in Edmonton, Canada. Omrane Guedhami is an

Associate Professor at the Darla Moore School of Business at the University of South Carolina in Columbia, SC. Chuck

Kwok is the Distinguished Business Partnership Foundation Fellow and Professor of International Business at the Darla

Moore School of Business at the University of South Carolina in Columbia, SC. Liang Shao is an Assistant Professor of

Finance at the Hong Kong Baptist University, Hong Kong.

1 These findings on the role of property rights and external finance in profit reinvestment are echoed in Chakravarty and Xiang (2011) and Ayyagari, Demirgüç-Kunt, and Maksimovic (2010, 2011).

Financial Management • Spring 2016 • pages 37 – 65

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38 Financial Management Spring 2016

We are interested in the role of national culture for economic growth in emerging economies for

two reasons. First, in such economies where formal institutions are weaker, informal institutions

such as national culture should matter more. Hence, we should be more likely to observe a

direct effect of informal institutions, as opposed to an indirect effect through formal institutions.

Hofstede (2001) shows that national culture and economic development are correlated. However,the literature has yet to identify a clear channel through which informal institutions affect the

economy. A direct association between culture and profit reinvestment may provide one answer.

Second, because culture is located at the most basic level in a stratified system of institutions

(Williamson, 2000), and formal institutions must be compatible with culture in order to be

effective (Licht, Goldschmidt, and Schwartz, 2005), the effectiveness of efforts to increase the

level of economic development (e.g., by facilitating profit reinvestment) is likely to depend on a

country’s cultural profile.

To proxy for culture, we focus on two cultural dimensions from Schwartz’s (1994) widely

accepted framework: Embeddedness, which captures cultural emphasis on conformity and the

status quo, and Hierarchy, which captures cultural acceptance of an unequal distribution of power.

These dimensions may affect reinvestment indirectly, through their correlations with formal insti-

tutions such as economic development, political rights, and economic freedom (Schwartz, 2006),

or directly, through their effect on the motivation to invest. To the extent that our sample focuses

on emerging markets with similarly weak formal institutions and a large number of small firms

for which investment policies are largely determined by managers’ individual investment moti-

vations, culture is more likely to exert a direct effect than an indirect effect on reinvestment. We

obtain profit reinvestment and other firm-level information from the 2002 to 2005 standardized

Enterprise Surveys conducted by the World Bank. Using this information, we construct a sample

of 5,752 small firms from 22 emerging economies.

To control for indirect channels of the effect of culture and distinguish firm- versus country-

level effects, we employ a hierarchical linear model (HLM) following Li et al. (2013). Wefind that Embeddedness and Hierarchy are negatively correlated with profit reinvestment,

after controlling for firm characteristics, other informal institutions such as trust and reli-

gion, and formal institutions such as economic development, economic freedom, political

rights, transition economy, legal protection, and financial market development. Furthermore,

for the most part, the formal institutions considered do not affect profit reinvestment signifi-

cantly, which suggests that the documented effect of culture is mainly due to the direct link

and that culture matters for firms in emerging markets characterized by a weak institutional

environment.

To mitigate the endogeneity concern that our results may be driven by a failure to control for

institutions that determine both culture and profit reinvestment, we instrument Embeddedness

and Hierarchy with a country’s latitude as well as its religious composition and fractionalization.

The effect of culture on profit reinvestment persists in the two-stage instrumental variables

regression. We also test whether alternative explanations could be behind a lower motivation

to invest. In particular, firms in high-Embeddedness and -Hierarchy countries may reinvest less

profit because they 1) rely more on external financing such as debt, 2) are subject to greater

constraints on investment, 3) have more internal funds, 4) face less competition, or 5) have

different corporate governance structures. Our analyses do not lend support to these alternative

explanations.

In additional analyses, we investigate whether the two formal institutions previously identified

as determinants of profit reinvestment—namely, access to external financing and strength of

property rights—affect prof it reinvestment differently across different cultures. We find that ac-cess to external financing (strength of property rights) is more important for profit reinvestment

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El Ghoul et al. National Culture and Profit Reinvestment 39

in low (high)-Embeddedness and -Hierarchy countries, consistent with the view that Embed-

dedness and Hierarchy are associated with a lower motivation to invest. In low-Embeddedness

and -Hierarchy countries where firm owners/managers tend to engage in large-scale investment,

availability of external financing is more important to profit reinvestment decisions. In con-

trast, in high-Embeddedness and -Hierarchy countries where people tend to invest less, firmowners/managers may care more about the strength of property rights when reinvesting profit.

These results suggest that regulatory incentives to motivate investment should be based on a

country’s cultural profile.

This study contributes to the literature on economic growth by showing that an informal

institution—national culture—is a determinant of economic development. The effect of culture

on profit reinvestment suggests a possible explanation for why countries with strong versus weak

formal institutions develop differently. Furthermore, although the literature generally agrees

that formal institutions such as strength of property rights and access to external financing are

conducive to economic growth, the role of culture has yet to receive attention. We show that the

effectiveness of formal institutions depends on the cultural environment.

This study also contributes to the literature on culture and finance. Empirical work in this

area focuses on public corporations from developed and popular developing countries, and is

subject to the concern that the effect of culture is spurious due to a failure to control for important

country-level institutions and firm-level characteristics in the analysis. This study generates

cleaner results on the direct effects of culture by examining small firms from emerging markets.

First, formal institutions in emerging markets tend to be weak, and hence it is less likely that

important institutions are omitted. Furthermore, our HLM distinguishes between country- and

firm-level effects, and hence is more likely to provide evidence on the direct effects of culture.

Second, 75% of our sample of small firms are controlled by families or individuals, whose

investment decisions are more likely to be influenced by cultural values than those of larger f irms

with more complex governance structures. Third, globalization may compromise the impact of domestic culture on corporate decisions, but our sample of small firms is to a lesser extent subject

to this concern (7% of the sample firms have a large foreign shareholder, 8% have holdings or

operations in foreign countries, and 22% have exports).2

The remainder of the paper is organized as follows. In Section I, we discuss the indirect and

direct links between national culture and profit reinvestment decisions. Section II describes the

data, our methodology, and the main results. Sections III and IV address endogeneity and examine

alternative explanations for our results, respectively. Section V examines variation in different

stimuli for profit reinvestment across cultures. Section VI concludes.

I. Possible Links between Culture and Profit Reinvestment

A. Relevance of National Culture

National culture has gained increasing attention in the finance literature.3 Central to a country’s

culture is a set of prevailing values with respect to what is considered good and desirable

2 In robustness tests, we show that controlling for foreign ownership and exports does not affect the role of culture.

3 For example, recent studies document that for public firms from both developed and developing countries, national

culture is associated with leverage (Chui, Lloyd, and Kwok, 2002), dividend payments (Shao, Kwok, and Guedhami,

2010), earnings management (Han et al., 2010), international mergers volume and synergy gains (Ahern, Daminelli, and

Fracassi, 2015), cross-border investment flows (Siegel, Licht, and Schwartz, 2011), debt maturity (Zheng et al., 2012),corporate investment (Shao, Kwok, and Zhang, 2013), and corporate risk-taking (Li et al., 2013).

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(Schwartz, 2006) that shape every aspect of a society, from individual behaviors to institutional

arrangements, and distinguish people of one country from those of another (Hofstede, 2001). In

line with the fundamental role of culture, Williamson (2000) proposes a four-level framework

of economic and social analysis in which informal institutions such as culture (Level 1) impose

constraints on formal institutions (Level 2) and in turn governance structures (Level 3) and resource allocation decisions (Level 4).4

In our context, there are two possible channels through which culture (Level 1) can affect

profit reinvestment decisions (Level 4). First, culture can indirectly affect reinvestment through

its effect on formal institutions (Level 2) that impact firm-level investment decisions. Governance

structures (Level 3) are likely to be less important in this indirect channel because our sample

comprises small firms with similar governance structures.5 Second, because it is impossible to

completely contract upon all contingencies (bounded rationality; see Aggarwal and Goodell,

2009), formal institutions alone cannot govern economic outcomes. Among emerging markets,

where formal institutions are less developed, culture is also likely to have a direct effect on

reinvestment.

To test the effects of national culture, in this paper we proxy for culture using Schwartz’s

(1994) framework, as it has country coverage for 22 of the emerging markets in our sample. 6

Drawing on social science theories, Schwartz (1994) identifies three basic issues that confront

societies. He captures the extent to which a country emphasizes a particular basic issue using

three corresponding sets of bipolar cultural dimensions: Embeddedness-Autonomy, Hierarchy-

Egalitarianism, and Harmony-Mastery.7

According to Schwartz (1994, 2006), the Embeddedness-Autonomy dimension captures the

relationship between the individual and the group. High-Embeddedness cultures emphasize

the status quo and in-group solidarity, while high-Autonomy cultures encourage individuals

to express their ideas and preferences. The Hierarchy-Egalitarianism dimensions reflect how

a society organizes to preserve the social fabric. High-Hierarchy cultures rely on hierarchicalstructures to ensure responsible and productive behavior, and consider the unequal distribution

of power as legitimate, while high-Egalitarianism cultures recognize people as moral equals

and are concerned about the welfare of all. Finally, Harmony-Mastery captures the relationship

between society and the natural and social worlds. High-Harmony cultures emphasize fitting

into the world as it is rather than changing, directing, or exploiting it, while high-Mastery

cultures encourage active self-assertion in order to master and change the natural and social

environment.

Small firms in emerging markets are subject to investment risk due to state expropriation

and weak infrastructure and institutional support. Besides, the small firms in our sample seem

to engage in risky investments, for example, innovations and new products: with the limited

information in the data set, we find that in the last three years, 40% of the firms developed

a major new product line, 60% upgraded the existing product line, and 33% introduced new

technologies that significantly changed the way that main products were produced.8 Thus, in

4 Because cultural values are reinforced by the institutions that themselves are products of the dominant cultural system

(Hofstede, 2001), national culture is stable over time and hence can be used to predict observable behaviors.

5 Of thesmallf irmsin oursample, 95%are private firms, 83%have a chief executive officer(CEO)who is thef irm’s largest

shareholder, 73% have a dominant shareholder with more than 50% ownership, and 75% are controlled by individuals or

families. However, we show later that our results are robust to controlling for these governance characteristics.

6 In contrast, Hofstede’s (2001) widely used index covers only 13 of the emerging markets in our sample.

7 Schwartz (1994) distinguishes between two types of autonomy: Intellectual Autonomy and Affective Autonomy.8 We also find that these patterns in the data are not significantly correlated with the cultural dimensions.

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the following subsections, we propose possible links between reinvestment and the first two sets

of aforementioned dimensions, which are associated with the willingness to innovate and take

risk.9 We do not propose a hypothesis for (but do empirically test) the effect of the Harmony-

Mastery dimensions because it is hard to clearly link the values emphasized by these dimensions

to risk-taking. These dimensions are more likely to exert effects on how a firm interacts withsociety, and the scale of investment is not likely a question of “fitting into” versus “mastering” the

external world. We do conjecture, however, that the Harmony-Mastery dimensions affect the type

of investment (e.g., environmentally friendly vs. unfriendly, or collaborative vs. competitive), if

not necessarily the scale.

B. Indirect Channels

The development of national institutions that affect firm investment varies across countries.

These formal institutions can reinforce cultural values but at the same time must be compatible

with the local culture to be effective and thus are reciprocally influenced by culture (Schwartz,

2006). Previous literature on culture and corporate finance argues that culture has an indirect

effect on firm behavior through legal and financial institutions (e.g., Li et al., 2013; Boubakri

et al., 2014) such as the level of stock market development (Kwok and Tadesse, 2006) and the

strength of investor protection (Licht et al., 2005).

Table I reports correlations between the cultural dimensions of interest, reinvestment, and

various proxies for formal institutions. For themost part, we do notobserve significant correlations

between the cultural dimensions of interest and the level of stock market development, the strength

of legal protection, and the two formal institutions important to profit reinvestment in emerging

markets according to prior research (i.e., access to external financing and strength of property

rights). These insignificant results are not surprising, as in our sample of emerging markets, most

countries have an immature stock market and weak investor protection. For example, annual stock market trading volume as a percentage of gross domestic product (GDP) is between 10% and

40% for six countries in our sample and less than 10% for the remaining 16 sample countries,

and all of the sample countries except the Philippines are of civil law origin.

However, the results in Table I also show that the cultural dimensions are associated with

other institutions relevant to small firms’ investment decisions. In particular, Embeddedness

and Hierarchy are significantly negatively correlated with economic development, political

rights, and economic freedom, which in turn are significantly positively related to reinve-

stment.10

C. Direct Channels

The cultural dimensions of interest can also directly affect the investment motivation of firm

managers. In high-Embeddedness countries, firm owners/managers are likely to have lower

9 We do not focus on uncertainty avoidance from Hofstede (2001) because uncertainty is not the same as risk. As Hofstede

(2001, p. 145) points out, “uncertainty avoidance should not be confused with risk avoidance.” Risk is often expressed

by probabilities that different events may happen, whereas uncertainty refers to a situation in which one does not know

what may happen. Uncertainty avoidance often leads to formal structures and rules to reduce anxiety about ambiguity

(not risk) and these formal structures do not necessarily reduce risk-taking. In unreported tests, we find that uncertainty

avoidance has an insignificant and negative coefficient for reinvestment and, interestingly, is negatively correlated with

Embeddedness.

10 Table I also shows that Embeddedness and Hierarchy are negatively associated with a country’s banking credit, which

is positively associated with REINVEST. However, we lack a strong theoretical explanation from the literature for whythese two cultural dimensions affect banking credit.

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Table I. Culture, Profit Reinvestment, and Formal Institutions

This tablepresents country-level correlations between the cultural dimensions of interest, profit reinvestment,and formal institutions. REINVEST is a continuous variable based on the reported percentage of profit

reinvestment. EMBEDDED and HIERARCHY are national culture scores from Schwartz (1994). LN_GDPis the natural logarithm of a country’s GDP per capita in 2000 US$ from World Development Indicators.

POLITICAL_RIGHTS is the political rights index from Freedom House, with larger values indicating higher

political liberty. ECONOMIC_FREEDOM captures the extent to which private firms operate freely in acountry in 2002. CREDIT_MARKET is the total value of banking credit scaled by GDP. STOCK_MARKET

is total value traded in the stock market scaled by GDP. ANTI_DIRECTOR and CREDITOR RIGHTS areshareholder creditor protection indexes from Djankov et al. (2008) and (2007), respectively. PRIVATE

is a dummy variable equal to one if the firm has shares held by private interests and zero otherwise.

BANK_LOAN is a dummy variable equal to one if the firm has one or more bank loan(s) and zerootherwise. INFORMAL_PAYMENT is total gifts or informal payments to public officials as a percentage

of total sales. JUDICIAL_ENFORCEMENT is the manager’s response to “On a scale of 1–6 (fully disagreeto fully agree), I am confident that the judicial system will enforce my contractual and property rights in

business disputes.” LN_AGE is the natural logarithm of the number of years the firm has operated in the

country. LN_SIZE is the natural logarithm of the number of permanent and temporary employees of thefirm during the previous survey year. EXPORTER is the percentage of sales exported directly or indirectly.

REINVEST EMBEDDED HIERARCHY

REINVEST –0.70∗∗∗ –0.47∗∗

LN_GDP 0.58∗∗∗ –0.84∗∗∗ –0.58∗∗∗

POLITICAL_RIGHTS 0.53∗∗ –0.47∗∗ –0.50∗∗

ECONOMIC_FREEDOM 0.43∗ –0.42∗ –0.38∗

CREDIT_MARKET 0.47∗∗ –0.50∗∗ –0.52∗∗

STOCK_MARKET 0.05 –0.32 0.14

ANTI_DIRECTOR –0.11 0.14 –0.17

CREDITOR_RIGHTS 0.10 –0.30 –0.32PRIVATE 0.29 –0.11 0.14

BANK_LOAN 0.20 –0.20 –0.34INFORMAL_PAYMENT 0.21 –0.17 0.20

JUDICIAL_ENFORCEMENT 0.00 –0.04 –0.15

LN_AGE 0.16 –0.31 –0.18LN_SIZE –0.36∗ 0.40∗ 0.34

EXPORTER 0.02 0.17 –0.02

∗∗∗Significant at the 0.01 level.∗∗Significant at the 0.05 level.∗Significant at the 0.10 level.

motivation to invest for four possible reasons. First, more (less) Embeddedness is associated

with respect of tradition (creativity). Firm owners/managers in high-Embeddedness countries

are more likely to follow existing norms and practices, and hence invest less in innovations.

Second, in low-Embeddedness countries, corporate policies tend to be autonomous decisions

by firm owners/managers, but in high-Embeddedness countries are to a larger extent subject to

other stakeholders’ opinions. Embeddedness emphasizes group solidarity among stakeholders,

including shareholders, creditors, and employees, which constrains firm owners/managers

from making risky investment. Consistent with this argument about the association between

Embeddedness and risk-taking, Chui et al. (2002) find that high Embeddedness is correlated

with less firm debt among public corporations, as the financial distress risk of overborrowingconflicts with a cultural emphasis on group security, and Li et al. (2013) f ind a negative

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association between collectivism (a cultural dimension from Hofstede, 2001, that is similar to

Embeddedness) and corporate risk-taking.11,12 Third, low Embeddedness encourages pursuing

individual accomplishments such as through performance-based compensations. This may

also enhance managers’ motivation for investment and innovation in low-Embeddedness

countries. Fourth, managers must have confidence in their forecasts of future payoffs and their execution capabilities before making an investment. People tend to be less (more) confident in

high-Embeddedness (Autonomy) countries (e.g., Markus and Kitayama, 1991), implying lower

(higher) motivation to invest in high-Embeddedness (Autonomy) countries.13

Turning to our second cultural dimension, in high-Hierarchy countries, centralized power and

top-down control within a firm stifles innovation because the power and roles of managers and

subordinates are strictly defined in a hierarchical structure. In line with this view, the literature

shows that power distance—a cultural dimension in Hofstede’s (2001) framework that is similar to

Hierarchy—is associated with low innovation (Shane, 1992; Varsakelis, 2001). A second reason

for a negative association between Hierarchy and reinvestment lies in the fact that the stability of

a hierarchical structure (firm) is important to both managers and subordinates. Managers in high-

Hierarchy countries enjoy higher compensation (Tosi and Greckhamer, 2004) and are entitled to

authoritative power. In turn, subordinates expect superiors to provide job security in exchange

for obedience. Therefore, in high-Hierarchy countries, managers at the top of the hierarchy are

likely to be reluctant to commit to risky investment.14 Last, there is less mobility between social

classes in high-Hierarchy societies because people tend to accept unequal distribution of power.

This cultural emphasis may make managers of small and medium-sized enterprises (SMEs) less

motivated to increase investment to challenge large/mature firms.

In summary, due to the association between Embeddedness/Hierarchy and a lower investment

motivation, we predict negative direct effects of these cultural dimensions on profit reinvestment.

We argue that this direct effect should be more pronounced for small firms in emerging markets for

three reasons. First, culture should matter more for firms operating in emerging markets whereformal institutions are weak. Second, because small firms have similar corporate governance

structures, cultural values of firm decision makers are more likely to explain the variation of

11 Firm owners/managers are also embedded in a social network comprising their family members and friends. Hsee

and Weber (1999) argue that in high-Embeddedness countries, this network is stronger and works as a cushion against

possible losses because people tend to help one another within the network, leading to more risky investment. This

argument is echoed by Chui and Kwok (2008) who find that Embeddedness is associated with lower life insurance

consumption. However, this “cushion hypothesis” should not have first-order importance in emerging markets, because

people cannot always expect to receive considerable support from family members and friends who are very likely to

be also financially constrained. On the contrary, we can argue that knowing that they have obligations to assist, network

members in high-Embeddedness countries may have expectations for less risk-taking.

12 The negative association between Embeddedness and debt suggests that there is greater profit reinvestment in high-Embeddedness countries, in which case the net effect of Embeddedness on profit reinvestment depends on the relative

importance of lower investment motivation and less reliance on external financing. However, the results in Table VI

show that culture does not affect debt usage in new investment among small firms in our sample, hence preference

for leverage is not a major factor driving profit reinvestment. Even if small firms in high-Embeddedness countries use

less debt, a negative association between Embeddedness and reinvestment still suggests lower investment motivations in

high-Embeddedness countries.

13 Chui, Titman, and Wei (2010) find that individualism is positively associated with momentum-trading profits, which

they attribute to individualism capturing overconfidence and self-attribution.

14 A possible counterargument is that managers in high-Hierarchy countries have more authority andthus are more likely to

invest in empire-building. We do not think this is a major concern in our context because small firms in emerging markets

are subject to higher uncertainty and greater risk of state expropriation when expanding their scale of investment, so the

question of whether to build a bigger kingdom still depends on the decision maker’s risk preference. In high-Hierarchy

countries, a superior’s authority is accepted by subordinates who expect the hierarchy to be stable, and hence Hierarchyshould still be associated with lower risk-taking.

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investment policies. Third, small firms are less affected by globalization and foreign ownership,

suggesting a stronger effect of culture.

II. Data, Methodology, and Main Results

A. Data

We collect firm-level data, including information on profit reinvestment, from the 2002 to

2005 standardized Enterprise Surveys conducted by the World Bank.15 Following a uniform and

stratified random sampling method and covering a wide range of registered small businesses

in numerous sectors across countries, these surveys collect information on the investment en-

vironment of economies around the world. Specifically, they provide firm-level data on profit

reinvestment, ownership structure, strength of property rights, and access to external financing,

among other indicators. After removing observations with missing information required for our

study and removing developed countries and countries not covered by Schwartz’s cultural index,

we obtain a sample of 5,752 firms across 22 emerging and transitional economies.

B. Methodology

To test our predictions, we run various specifications of the following HLM:16

REINVEST = β0 + β1 · Cultural Dimension + β2 · Country Level Controls

+β3 · Country Means of Firm Level Controls

+β4 · Demeaned Firm Level Controls + . (1)

HLM allows us to decompose the explanation of firm-level profit reinvestment into firm-

versus country-level determinants, and thus increase the fit to our two-level (firm and country)

data. A central feature of HLM is centering firm-level independent variables on their respective

country means while adding in their country means. This has several advantages in our context.

First, the country mean-centered firm-level variables capture within-country variance in firm

characteristics, which helps explain why reinvestment varies within a country, while the country

means of firm-level predictors (together with other country-level controls) capture differences in

institutional environment across countries, which help explain why reinvestment differs across

countries. Second, the addition of f irm-level predictors’ country means captures culture’s indirect

effects on profit reinvestment and thus separates out the direct effects on reinvestment. Third,

because firm-level deviations better explain within-country variance of the dependent variable,

their coefficients are more informative about whether the role of firm-level factors (e.g., access

to bank loans and strength of property rights) for reinvestment differs across cultures.

In Equation (1), the dependent variable is REINVEST, a continuous variable that gives the

reported percentage of profit reinvestment. Table II, which provides summary statistics, shows

that REINVEST varies considerably across emerging economies, ranging from 23.41 (Georgia)

15 Details on these surveys are available at https://www.enterprisesurveys.org.

16 We thank an anonymous reviewer for suggesting the use of the HLM framework. In unreported tests, we find that our results continue to go through using Tobit or ordered logit models.

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Table II. Profit Reinvestment and National Culture across Countries

This table presents the distribution and averages of key variables used in this paper. REINVEST is a con-tinuous variable based on the reported percentage of profit reinvestment. EMBEDDED and HIERARCHY

are national culture scores from Schwartz (1994).

Country N REINVEST EMBEDDED HIERARCHY

Bosnia and Herze. 137 53.26 4.01 1.73Bulgaria 177 52.98 3.87 2.68

Chile 535 58.95 3.64 2.25

Costa Rica 212 77.21 3.49 2.29Croatia 198 57.63 3.57 2.44

Czech Republic 258 47.98 3.59 2.22

Estonia 132 65.08 3.81 2.04Georgia 102 23.41 4.12 2.46

Hungary 372 74.36 3.60 1.94

Indonesia 557 28.54 4.27 2.56Latvia 109 68.85 3.83 1.80

Macedonia 122 60.58 3.91 2.72Philippines 168 45.60 4.03 2.68

Poland 885 43.10 3.86 2.51Romania 422 64.75 3.78 2.00

Russian Federation 438 35.76 3.81 2.72

Senegal 128 38.82 4.45 2.63Slovak Republic 104 53.42 3.82 2.00

Slovenia 175 53.59 3.71 1.62Turkey 58 56.83 3.77 2.97

Uganda 113 36.35 4.23 2.99

Ukraine 350 55.29 3.93 2.56Total/Average 5,752 50.98 3.85 2.36

to 77.21 (Costa Rica). The primary independent variables of interest are EMBEDDED and

HIERARCHY, which are the scores of the two cultural dimensions of interest.

At the country level, we control for the logarithm of GDP per capita (in 2000 US$) from

the World Development Indicators, because the level of economic development explains much

of the difference in investment environment across countries. We also include country means

of firm-level controls (see next paragraph) to capture cross-country differences in institutional

environment that manifest in firm characteristics.

At the firm level, we control for four groups of variables previously shown to explain profit

reinvestment (Johnson et al., 2002; Cull and Xu, 2005; Chakravarty and Xiang, 2011). First, we

control for PRIVATE, a dummy variable equal to one if the firm’s shares are held by private

interests, and zero otherwise. Private firms may be subject to less government intervention and

have a higher motivation to invest. We thus expect to see a positive correlation between private

ownership and profit reinvestment. Second, we control for BANK_LOAN, a dummy variable

equal to one if the firm has one or more bank loan(s), and zero otherwise. Access to external

financing can be important because few firms in our sample (< 5%) raise equity to fund new

investment. We find that in our sample, firms do not necessarily exhaust all the internal capital

before using debt: the average profit-reinvestment rate is 57% among firms with one or moreloans. Although the pecking order theory does not work well in our sample, access to external

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financing can be positively correlated with profit reinvestment to the extent that access to bank

loans represents a large investment scale (Cull and Xu, 2005).17 Third, we control for strength

of property rights using two variables. INFORMAL_PAYMENT is the percentage of total sales

spent on informal payments or gifts to public officials. This measure captures the risk of gov-

ernment expropriation and corruption, an important dimension of strength of property rights. Weexpect INFORMAL_PAYMENT to be negatively correlated with profit reinvestment, if current

informal payments to public officials represent the perception of future government corruption

and expropriation. Under high government corruption and expropriation, more investment im-

plies more informal payments when investment is successful but zero refund when investment

fails. Thus, more government corruption and expropriation reduces expected investment returns.

Theoretically, this correlation may instead be positive if informal payments bring more investment

opportunities to the firm. However, only 3% of our sample firms indicate that private payments

to government officials have a major or decisive impact on their business, and thus in our study

INFORMAL_PAYMENT is more likely to proxy for the degree of government expropriation. We

also use JUDICIAL_ENFORCEMENT, which is the manager’s response to “On a scale of 1–6

(fully disagree to fully agree), I am confident that the judicial system will enforce my contractual

and property rights in business disputes.” Judicial enforcement should facilitate investment, but

it may benefit small businesses less because small firms cannot afford the expenses associated

with going to court. Finally, we control for three general firm characteristics, namely, LN_AGE,

the natural logarithm of the number of years the firm has operated in the country; LN_SIZE,

the natural logarithm of the number of permanent and temporary employees during the previous

survey year; and EXPORTER, the percentage of sales exported directly or indirectly.18 Recall

that in the regressions we center the above firm-level controls on their respective country means

(i.e., obtain firm-level deviations).

C. Main Results

In Table III, we report the HLM results on the effects of Schwartz’s (1994) cultural dimen-

sions on the profit reinvestment decisions of small firms in emerging markets. In model 1,

we regress REINVEST on the country- and firm-level controls, abstracting from national cul-

ture. At the country level, we find that the level of economic development (LN_GDP) has a

positive effect on profit reinvestment (a significant coefficient of 10.296). PRIVATE, INFOR-

MAL_PAYMENT, and LN_AGE also have significant coefficients. It is interesting to observe

that INFORMAL_PAYMENT on the country level has a significant and positive coefficient. This

could be explained by the negative correlation between INFORMAL_PAYMENT and Embed-

dedness (Table I and notice that when Embeddedness enters the regression in model 2, INFOR-

MAL_PAYMENT loses its significance). It is also possible that INFORMAL_PAYMENT on thecountry level captures cross-country differences in investment opportunities (e.g., if a country’s

17 We find this to be the case using information on the portion of new investment financed by internal fund (INTER-

NAL_FINANCE). Assuming that reinvested profit is a measure of internal fund used for new investment, we can generate

a measure of investment size relative to a firm’s current net income by REINVEST/INTERNAL_FINANCE. We find that

with all the control variables in Table III, this measure of investment size relative to current net income is significantly

associated with access to bank loans, suggesting that access to external financing is related to investment size.

18 In unreported tests, we control for additional variables related to property rights and access to external financing:

TRADE_CREDIT takes a value of one if some share of the firm’s financing is via trade credit and zero otherwise;

POLITICAL_CONNECTION takes a value of one if the firm owners/managers lobby the government with respect to

laws and regulations and zero otherwise; and DISPUTE_RESOLVED is the percentage of firm disputes over payments

resolved by court action over the past two years. Controlling for these additional variables reduces the sample byapproximately half but does not change our results. None of these additional variables has a significant coefficient.

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Table III. Cultural Dimensions and Profit Reinvestment by Small Businesses inEmerging Economies

This table presents results from hierarchical linear models (HLM) assuming a random intercept across

countries. The dependent variable is REINVEST, a continuous variable based on the reported percentageof profit reinvestment. EMBEDDED and HIERARCHY are national culture dimensions of interest from

Schwartz (1994). LN_GDP is the natural logarithm of a country’s GDP per capita in 2000 US$ from World Development Indicators. PRIVATE is a dummy variable equal to one if the firm has shares held by private

interests and zero otherwise. BANK_LOAN is a dummy variable equal to one if the firm has one or more

bank loan(s) and zero otherwise. INFORMAL_PAYMENT is total gifts or informal payments to publicofficials as a percentage of total sales. JUDICIAL_ENFORCEMENT is the manager’s response to “On a

scale of 1–6 (fully disagree to fully agree), I am confident that the judicial system will enforce my contractual

and property rights in business disputes.” LN_AGE is the natural logarithm of the number of years the firmhas operated in the country. LN_SIZE is the natural logarithm of the number of permanent and temporary

employees of the firm during the previous survey year. EXPORTER is the percentage of sales exported directly or indirectly. Industry dummies and intercepts are included in the regressions but not reported

for brevity. Robust standard errors adjusted for country-level clustering are reported in parentheses. Thevariables in bold face are the ones of interest.

(1) (2)

Country Firm-Level Country Firm-LevelLevel Deviations Level Deviations

EMBEDDED –52.89∗∗∗

(19.95)

HIERARCHY –13.19∗∗∗

(3.81)

LN_GDP 10.29∗∗∗ –4.91(3.17) (6.54)

PRIVATE 91.99∗∗ 6.04∗∗ 38.40 6.03∗∗

(37.82) (2.53) (34.68) (2.54)

BANK_LOAN 50.00 6.39∗∗∗ 21.08 6.40∗∗∗

(32.91) (1.81) (31.89) (1.80)INFORMAL_PAYMENT 7.00∗∗ –0.04 3.61 –0.04

(2.79) (0.16) (3.14) (0.16)

JUDICIAL_ENFORCEMENT 5.59 –0.80 0.20 –0.80(8.10) (0.53) (6.79) (0.53)

LN_AGE –41.98∗ –1.89 –28.73 –1.87(25.37) (1.31) (19.93) (1.30)

LN_SIZE –2.77 2.10∗∗∗ –3.33 2.09∗∗∗

(4.79) (0.66) (4.44) (0.65)EXPORTER 13.76 2.60∗ 65.58∗ 2.64∗

(30.39) (1.50) (34.92) (1.50)

Industry dummies/intercept Yes Yes

N of countries 22 22

N of observations 5,752 5,752


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public officials on average receive more gifts from SMEs, it may imply that SMEs in that country

are profitable enough to afford them). At the firm level, private ownership (PRIVATE), access

to external financing (BANK_LOAN), firm size (LN_SIZE), and EXPORTER are positively

associated with profit reinvestment, consistent with previous literature.

In model 2, we include the cultural dimensions EMBEDDED and HIERARCHY, both of whichare significantly and negatively associated with profit reinvestment.19,20 The results continue to

hold if we include these two cultural dimensions in the regression separately. This suggests that the

values emphasized by EMBEDDED and HIERARCHY are relevant to reinvestment decisions.21

The economic significance of the coefficients on EMBEDDED and HIERARCHY is also

meaningful. In model 2, a one-standard deviation increase in Embeddedness and Hierarchy

corresponds to a respective 12% and 5% reduction in reinvestment as a percentage of profit. Fur-

thermore, all the country-level controls (including the country means of firm-level controls) that

have significant coefficients in model 1 lose their effects, suggesting that culture (Embeddedness

and Hierarchy) affects reinvestment mostly through the direct channel (in a statistical sense) and

that informal institutions are likely to matter more in emerging markets where formal institutions

are weakly developed.22

III. Endogeneity

Mutual causality between national culture and profit reinvestment is not likely in this study.

First, the national culture scores (which capture cultural values established in one’s early life)

were collected in the early 1990s, about 10 years before the profit reinvestment decisions that we

analyze were made. Thus, if there is any causal relationship between national culture and profit

reinvestment, it is likely to run from culture to reinvestment decisions. Second, it is unlikely

that a firm-level decision (profit reinvestment) significantly influences a country-level variable(culture). However, the effect of national culture on profit reinvestment may be influenced by

omitted variables that determine both culture and profit reinvestment. We address this endogeneity

concern using two approaches, as discussed below.

A. Additional Controls

Although variation in formal institutions across emerging markets is not likely to be consider-

able, as we explain above it is possible that our main analysis omits important institutions related

to both culture and profit reinvestment. In Table IV, we address this concern by considering the

following additional controls.

First, we examine whether the effect of culture in Table III is due to a failure to control for twoother important cultural variables. In model 1, we additionally include HARMONY (including

19 Although our sample is relatively balanced across countries as no country accounts for more than 20% of the sample,

we reestimate model 2 Table III after dropping the three (five) countries with more than 500 (400) observations. The

results (untabulated) are qualitatively similar.

20 In untabulated results, we find that Autonomy and Egalitarian are not significantly associated with profit reinvestment.

21 In unreported tests, we also replace EMBEDDED and HIERARCHY with Hofstede’s (2001) respective dimensions,

namely, Individualism and Power Distance. Individualism does not show a significant effect, but Power Distance has a

significantly negative coefficient.

22 If EMBEDDED and HIERARCHY have largely indirect effects on reinvestment through their correlations with eco-

nomic development and formal institutions as captured by the country means of firm-level controls, then the coefficients

on the country-level controls in model 2 should be similar to their counterparts in model 1, in which case the two culturaldimensions will not have significant coefficients.

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Table IV. Additional Controls

This table presents results from rerunning model 2 in Table III with additional controls. The dependentvariable is REINVEST, a continuous variable based on the reported percentage of profit reinvestment.

EMBEDDED, HIERARCHY, and HARMONY are national culture scores from Schwartz (1994). TRUST isthe percentage of respondents from a country that believes people are generally trustworthy from World Value

Surveys. MUSLIM, CATHOLIC, and ORTHODOX are dummy variables indicating a country’s dominant

religion in 2000. ANTI_DIRECTOR and CREDITOR RIGHTS are shareholder creditor protection indexesfrom Djankov et al. (2008) and (2007), respectively. CREDIT_MARKET is the total value of banking credit

scaled by GDP. POLITICAL_RIGHTS is the political rights index from Freedom House, with larger valuesindicating higher political liberty. ECONOMIC_FREEDOM is a measure of the extent to which private

firms operate freely in a country in 2002. TRANSITION is a dummy variable indicating whether a country’s

economy is transitioning to a market economy. Other firm and country controls, industry dummies, and intercepts are also included in the regressions but not reported for brevity. Robust standard errors adjusted

for country-level clustering are reported in parentheses. The variables in bold face are the ones of interest.

(1) (2) (3) (4) (5) (6) (7)

EMBEDDED –52.88∗∗∗ –49.65∗∗∗ –82.45∗∗∗ –25.65∗ –58.62∗∗∗ –55.64∗∗∗ –54.88∗∗

(19.14) (18.98) (20.69) (15.23) (18.61) (19.19) (22.07)

HIERARCHY –11.53∗∗∗ –11.97∗∗∗ –11.58∗∗∗ –15.86∗∗ –10.75∗ –9.71∗∗∗ –13.88∗∗∗

(3.19) (4.08) (3.85) (7.71) (5.80) (4.35) (4.11)

HARMONY 15.14∗

(8.67)

TRUST –32.94∗∗

(16.59)

MUSLIM –30.32∗∗∗

(4.59)

CATHOLIC –25.67∗∗∗

(5.89)ORTHODOX –22.75∗∗∗

(7.68)ANTI_DIRECTOR 2.07

(2.57)

CREDITOR_RIGHTS –5.57∗

(3.24)

CREDIT_MARKET 0.27(0.18)

POLITICAL_RIGHTS –2.77

(4.01)ECONOMIC_FREEDOM 17.63

(10.74)TRANSITION –3.16

(7.87)

Firm/country controls Yes Yes Yes Yes Yes Yes YesIndustry dummies/intercept Yes Yes Yes Yes Yes Yes Yes

N of countries 22 19 22 15 22 20 20 N of observations 5,752 5,310 5,752 4,744 5,752 5,154 5,154


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MASTERY generates similar results). Li et al. (2013) show that Schwartz’s (1994) Harmony

dimension is negatively associated with corporate risk-taking. In model 2, we include TRUST,

which captures the extent to which people in a country regard one another as trustworthy and

comes from the World Values Survey. Recent literature shows that trust is associated with stock

market participation and economic exchange (Guiso, Sapienza, and Zingales, 2008, 2009).23Second, we examine whether our findings on the effect of culture on profit reinvestment is

due to a failure to control for religion, another important informal institution. In early work,

Weber (1905) shows that religion plays a significant role in social change. More recently, Stulz

and Williamson (2003) attribute the low level of creditor protection in Catholic countries to the

antiusury culture pervasive in the Catholic tradition, and Guiso, Sapienza, and Zingales (2003)

show that the main religion of a country is correlated with attitudes toward cooperation, market

economy fairness, and thrift, among others. Accordingly, in model 3 we include MUSLIM,

CATHOLIC, and ORTHODOX, which are dummy variables indicating a country’s dominant

religion in 2000.24

Third, we examine variables related to the legal environment and the level of financial devel-

opment. In particular, in model 4 we include ANTI_DIRECTOR, the revised antidirector index

of Djankov et al. (2008), and CREDITOR_RIGHTS, the creditor protection index of Djankov,

McLiesh, and Shleifer (2007), to capture the legal environment. To capture the level of financial

development, in model 5 we control for CREDIT_MARKET, the total value of banking credit

scaled by GDP. Because our sample mainly comprises private firms, stock market development

should not be relevant in our analysis (unreported results also show that stock market development

does not affect reinvestment in our sample).

Finally, we examine three variables that capture a country’s fundamental political and economic

freedoms. Controlling for political rights and economic freedom is important in this study because

Table I shows that they are correlated with both Embeddedness and Hierarchy and thus may be

an indirect channel for the effect of culture. In model 6, we include POLITICAL_RIGHTS, the political rights score from Freedom House multiplied by –1 so that higher scores indicate stronger

political rights. Countries with weak political rights are characterized by government corruption,

state expropriation, weak property rights, and weak rule of law. Recent international finance

literature finds that weak political rights and political instability are associated with a high cost of

capital (Qi, Roth, and Wald, 2010; Ben-Nasr, Boubakri, and Cosset, 2012; Boubakri, El Ghoul,

and Saffar, 2014) and deter corporate investment (Julio and Yook, 2012). Model 6 also includes

ECONOMIC_FREEDOM, a composite index from the Heritage Foundation multiplied by –1 so

that higher scores indicate more economic freedom, which considers government intervention,

fiscal and monetary policies, the ease of international investment and trade, how wages and prices

are determined, property rights protection, and the extent of informal markets. Model 7 controls

for TRANSITION, a dummy variable that indicates whether a country is transitioning from a

planned economy to a market economy.

The results in Table IV show that while controlling for the above institutional variables reduces

the number of countries in the sample, the effects of Embeddedness and Hierarchy on profit

reinvestment continue to persist. In particular, we find that profit reinvestment is positively

associated with Harmony (model 1) and negatively associated with trust (model 2), the three

23 In unreported tests, we also control for a variable measuring the extent to which people in a countrytrust the government,

which also comes from the World Values Survey. Our main results continue to hold, and the coefficient on government

trustworthiness is not significant.

24 The dominant religions in our sample include Catholic, Orthodox, Muslim, and Atheist. We omit the Atheist dummyto avoid the dummy variable trap.

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religion dummies (model 3), and creditor rights (model 4). In unreported tests, we find that

Harmony does not significantly affect reinvestment if Embeddedness and Hierarchy are not in

the regression, and thus its effect is possibly due to collinearity. It is not obvious why TRUST has

a negative coefficient. However, its significant effect disappears in the sample of 26 countries

for which we have scores of TRUST.25 Firms reinvest less in countries with a dominant religion,which is consistent with religious beliefs being negatively associated with risk-taking (e.g., Hilary

and Hui, 2009). Unreported tests show that the coefficients of the three religion dummies are not

significantly different. The effect of credit rights is not surprising, as stronger creditor protection

puts more constraints on managers’ ability to take risk, reducing investment. More important, most

of the formal institutions introduced in Table IV do not show significant effects on reinvestment,

suggesting that while culture is correlated with some of these formal institutions, the effect of

culture comes mostly from the direct channel rather than the indirect channel.

B. Instrumental Variables

An alternative approach to addressing missing factors is to use instrumental variables. In our

context, a valid instrument should be strongly correlated with culture (the relevance condition)

and at the same time affect profit reinvestment only through culture (the exclusion restriction).

As instruments we first consider measures of a country’s religious composition in 1900 (the

respective proportions of a country’s population that claim to be Catholic, Orthodox, Muslim,

and Atheist), as a country’s religious composition is viewed as an antecedent of cultural values

(La Porta et al., 1999; Stulz and Williamson, 2003; Siegel, Licht, and Schwartz, 2011) and hence

is viewed as exogenous. In addition, we instrument for Embeddedness and Hierarchy using a

country’s geographical latitude and religious fractionalization. Hofstede (2001) suggests that

in colder climates, individuals need to take more initiative to survive and thus tend to be less

collectivistic (similar to Embeddedness). Siegel et al. (2011) find that among ethnic, language, and religious fractionalizations, religious fractionalization best explains the Egalitarianism dimension

(the opposite of Hierarchy). To capture geographical latitude and religious fractionalization, we

employ TROPIC, a dummy variable equal to one if a country’s capital city lies in the tropics, and

FRACTIONALIZATION, the Herfindahl index of religious groups in a country in 1900.

We present the first-stage regression results in models 1 and 2 of Table V. The results show that

most of the instruments have significant coefficients with reasonable signs. The null hypothesis

of underidentification is also rejected at the 10% level. In model 3 we present the second-stage

regression results with two-step efficient generalized methods of moments (GMM) estimators.

The results show that the effects of Embeddedness and Hierarchy remain significant.

IV. Alternative Explanations

The findings that Embeddedness and Hierarchy are negatively correlated with profit rein-

vestment imply that firm owners/managers in high-Embeddedness and -Hierarchy countries

have lower motivation to invest. However, it may be the case that firms in high-Embeddedness

and -Hierarchy societies reinvest less profit because culture is associated with other structural

factors. For example, firms in high-Embeddedness and -Hierarchy societies may rely more on

external finance, face greater investment constraints, have more internal funds, operate in a less

25 The seven countries that have data available for TRUST but not for culture are Albania, Belarus, Salvador, Lithuania,Moldova, Tanzania, and Vietnam.

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Table V. Instrumental Variables

This table presents results from a two-stage Generalized Methods of Moments (GMM) model based onmodel 2 in Table III. Models 1 and 2 show the first-stage regression results, and model 3 provides the

second-stage GMM estimators. EMBEDDED and HIERARCHY are national culture scores from Schwartz(1994). REINVEST is a continuous variable based on the reported percentage of profit reinvestment.

The excluded instruments are the proportions of Catholics (CATHOLIC%), Orthodox (ORTHODOX%),

Muslims (MUSLIM%), and Atheists (NO_RELIGION%) in a country in 1900, FRACTIONALIZATION(the Herfindahl index of the religious groups in a country in 1900), and TROPIC (a dummy variable equal

to one if a country’s capital city lies in the tropics). Other firm and country controls are also included inthe regressions but not reported for brevity. The underidentification test reports the Kleibergen-Paap rk LM

statistic and the overidentification test reports the Hansen J statistic. Robust standard errors adjusted for

country-level clustering are reported in parentheses. The variables in bold face are the ones of interest.

First-Stage Regression Second-Stage Regression

(1) (2) (3)

Dependent Variable EMBEDDED HIERARCHY REINVEST

Excluded instruments

EMBEDDED –59.06∗∗∗

(15.16)

HIERARCHY –21.52∗∗∗

(7.01)

CATHOLIC% 0.01 –0.65∗∗

(0.08) (0.31)

ORTHODOX% 0.06 –1.18∗∗∗

(0.08) (0.34)

MUSLIM% 0.27∗∗ 0.32

(0.10) (0.51) NO_RELIGION% –6.65∗∗∗ 17.72∗∗∗

(0.73) (1.86)

FRACTIONALIZATION –0.25∗∗∗ 1.02∗∗

(0.08) (0.47)

TROPIC 0.41∗∗∗ –1.22∗∗

(0.11) (0.46)

Included instruments Yes Yes Yes F -test of excluded instruments 27.08∗∗∗ 20.10∗∗∗

Underidentification test 9.31∗ 9.31∗

Overidentification test 4.99


competitive environment, or face different governance structures. In this section, we examine

whether our results are driven by these alternative explanations.

A. Do Firms in High-Embeddedness/Hierarchy Countries Rely More on External

Finance?

We first consider the possibility that firm owners/managers in high-Embeddedness and -

Hierarchy countries may reinvest less profit simply because they prefer external financing over internal funds. Chui et al. (2002), for instance, find that firms in high-Embeddedness countries

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use less debt in a sample of developed countries, but prior evidence does not indicate whether this

result extends to developing countries. Fortunately, the Enterprise Surveys provide information

on how firms finance new investment. We find that only 3% of the sample firms finance new

investment with equity, so we focus on other forms of financing: internal funds, bank loans, trade

credit, and informal funds.In models 1 to 4 of Table VI, we use HLM to examine the relations between both Embedded-

ness and Hierarchy and INTERNAL_FINANCE, BANK_FINANCE, CREDIT_FINANCE, and

INFORMAL_FINANCE, respectively, where INTERNAL_ FINANCE is the percentage of new

investment financed by internal funds, BANK_FINANCE is the percentage of new investment

financed by local and foreign banks, CREDIT_FINANCE is the percentage of new investment fi-

nanced by trade credit, and INFORMAL_FINANCE is the percentage of new investment financed

by informal sources such as family members, friends, or informal money lenders. The results

show that neither of the two cultural dimensions significantly correlates with the four financing

choices, with one exception, namely, HIERARCHY is correlated with less trade credit usage. The

results therefore suggest that small firms in high-Embeddedness and -Hierarchy countries do not

have substantially different financing structures than those in low-Embeddedness and -Hierarchy

countries, and that the lower profit reinvestment in high-Embeddedness and -Hierarchy countries

represents a relatively smaller investment scale.

B. Do Firms in High-Embeddedness/Hierarchy Countries Face More

Constraints?

Consistent with evidence in Hofstede (2001), Table I shows that Embeddedness and Hierarchy

are significantly correlated with lower economic development. Accordingly, we next consider

the possibility that firm owners/managers in high-Embeddedness and -Hierarchy countries may

reinvest less profit because they face more constraints on investment rather than a lower motivation

to invest. To do so, we run subsample analyses in models 1 to 7 of Table VII.

In particular, in models 1 and 2 we repeat our main regression separately for the 11 countries

with higher economic development and the 11 countries with lower economic development in

terms of GDP per capita. In model 3, we control for 18 variables indicating the extent to which a re-

spondent declares the following issues as obstacles to investment: telecommunications, electricity,

transportation, access to land, tax rates, tax administration, customs and trade regulations, labor

regulations, skills and education of available workers, business licensing and operating permits,

access to collateral, interest rates, economic and regulatory policy uncertainty, macroeconomic

instability, corruption, crime, anticompetitive practices, and conflict resolution.26 Controlling for

these 18 issues eases concerns that firms in different cultures are subject to different political,infrastructure, macroeconomic, legal, financial, or social constraints. To further control for in-

vestment constraints, in model 4 we rerun the regression focusing on those firms that do not claim

major or very severe obstacles for any of the 18 issues above (1,262 firms from 20 countries).27

Next, in models 5 and 6 we divide the sample according to whether a firm has access to bank

loans. Firms with access to bank loans should have better investment opportunities. Finally, in

model 7 we run the regression using firms with exports, which should be less affected by local

investment constraints.

26 A firm’s responses to these 18 issues are given on a five-point scale, where 0, 1, 2, 3, and 4 correspond to no obstacle,

minor obstacle, moderate obstacle, major obstacle, and very severe obstacle, respectively.

27 In unreported analyses, we also run a regression focusing on those firms that claim no or minor obstacles for all 18issues (372 firms from 20 countries) and obtain similar results.

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Table VII. Subsample Analyses of the Effects of EMBEDDED and HIERARCHY onProfit Reinvestment

This table presents results from subsample analysis of the effects of EMBEDDED and HIERARCHY on

profit reinvestment based on model (2) in Table III. We report only the coefficients on EMBEDDED and HIERARCHY from Schwartz (1994). Other country/firm controls, industry dummies, and intercepts are

included in the regressions but not reported for brevity. Robust standard errors adjusted for country-levelclustering are reported in parentheses.

EMBEDDED HIERARCHY

(1) (2) (3) (4)Coefficient Standard Error Coefficient Standard Error

Panel A. Subsamples Based on Investment Constraints

1) High-GDP-per-capitacountries

–30.37∗∗∗ (3.60) –22.90∗∗∗ (2.41)

2) Low-GDP-per-capita

countries

–143.92∗∗∗ (10.79) –12.05∗∗∗ (2.25)

3) Controlling investment

constraints

–38.86∗ (21.36) –16.66∗∗∗ (4.69)

4) Firms with fewer investment constraints

–47.22∗ (25.25) –17.58∗ (9.19)

5) Firms with access to bank loans

–56.25∗∗∗ (10.67) –17.07∗∗∗ (3.92)

6) Firms without access to

bank loans

–55.40∗∗ (25.93) –8.95∗ (5.43)

7) Firms with exports –40.11∗∗∗ (17.17) –13.70∗∗ (5.37)

Panel B. Subsamples Based on Internal Funds

8) Firms with moderate profitreinvestment

–37.87∗∗ (18.06) –13.78∗∗∗ (3.19)

9) Firms with sufficient

internal fund

–65.42∗∗∗ (20.48) –11.08∗∗ (5.33)

Panel C. Subsamples Based on Degree of Competition

10) Firms facing higher

competition

–63.01∗∗∗ (19.14) –14.94∗∗∗ (3.85)

11) Firms facing lower

competition

–50.29∗ (26.51) –7.48 (5.55)

Panel D. Subsamples Based on Corporate Governance Structures

12) Family firms –54.69∗∗ (21.42) –8.36∗∗ (3.65)13) Firms without foreign

ownership

–48.81∗∗ (19.91) –13.34∗∗∗ (3.39)

14) Largest owner is also

CEO

–52.82∗∗∗ (19.96) –9.36∗∗∗ (3.29)

15) The largest shareholder owns > 75%

–47.74∗∗ (24.40) –11.93∗∗∗ (3.96)

16) The largest shareholder owns < 75%

–58.61∗∗∗ (16.92) –18.21∗∗∗ (5.19)

∗∗∗

Significant at the 0.01 level.∗∗Significant at the 0.05 level.∗Significant at the 0.10 level.

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In each of the above models, we expect culture’s effect to disappear if it is caused by culture’s

correlation with investment constraints. We find that the effects of Embeddedness and Hierarchy

continue to be negative and significant across all models, suggesting that culture’s correlation

with investment constraints is not driving our results.

C. Do Firms in High-Embeddedness/Hierarchy Countries Have More Internal

Funds?

We next look more closely at the role of internal funds, as firms in high-Embeddedness and

-Hierarchy countries have greater internal funds and hence do not need to rely on current net

income. For example, Truong et al. (2012) find that public firms in individualistic countries hold

less cash. In models 8 and 9 of Table VII, we rerun the regression for two subsamples of firms

with abundant internal funds. The first includes all firms reporting a profit reinvestment ratio

strictly between 0 and 100 (model 8). These firms should have neither extremely good nor zero

investment opportunities and thus should have enough internal funds to finance new investment.

The second subsample includes all firms that finance 100% of new investment using internal

funds (model 9). In both models, we find that the effect of culture on profit reinvestment continues

to go through.

D. Do Firms in High-Embeddedness/Hierarchy Countries Face Less

Competition?

It is also possible that firms in high-Embeddedness and -Hierarchy countries enjoy a dominant

position in their product markets and hence do not need to reinvest as much. This argument is

not likely to hold for our sample, which largely comprises small firms. However, to ensure such

an effect is not driving our results, we construct subsamples of firms facing a similar degree of competition using firms’ responses to the question “What will happen if you raise your prices

of your main product line or main line of services 10% above their current level in the domestic

market assuming that your competitors maintain their current prices?” We classify a firm as facing

higher competition if it replies “Our customers would continue to buy from us but at much lower

quantities or stop buying,” while we classify a firm as facing lower competition if it replies “Our

customers would continue to buy from us at the same quantities or slightly lower quantities.”

The results in models 10 and 11 of Table VII show that the effect of culture persists in the

high-competition subsample but becomes weaker in the low-competition subsample (Hierarchy’s

coefficient is significant only at the one-tailed 10% level). This finding suggests that culture’s

effect is impacted by how competitive the market is.

E. Do Firms in High-Embeddedness/Hierarchy Countries Have Different Agency

Concerns?

The last alternative explanation we consider is the possibility that firms in high-Embeddedness

and -Hierarchy countries have different corporate governance structures—that is, have different

agency concerns—than those in low-Embeddedness and -Hierarchy countries. To control for

agency concerns, in models 12 and 13 of Table VII we rerun the regressions for family firms

and firms without foreign ownership, respectively; in model 14 we focus on firms in which the

largest shareholder is also the CEO; and in models 15 and 16 we run the regressions for firms in

which the largest shareholder holds more than 75% or less than 75%. We find that the effect of culture remains unchanged for each of these subsamples of firms.

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V. Do the Effects of Access to Credit and Strength of PropertyRights Differ across Cultures?

Based on the evidence above that Embeddedness and Hierarchy are associated with a lower

motivation to invest, one may ask whether the effects of the two formal institutions previously

shown to influence profit reinvestment—namely, strength of property rights and access to external

financing (Johnson et al., 2002; Cull and Xu, 2005)—vary across different cultures. We conjecture

that the effects of these institutions should vary across cultures because formal institutions must

be compatible with informal institutions to be effective (Licht et al., 2005; Licht, Goldschmidt,

and Schwartz, 2007). In high-Embeddedness and -Hierarchy countries, firm owners/managers

have less motivation to take risk and may care more about the likelihood of expropriation by the

government (expropriation itself is a source of risk). At the same time, because leverage increases

bankruptcy risk, access to bank loans may not encourage firm owners/managers to invest their own

money in high-Embeddedness/Hierarchy countries as much as in low-Embeddedness/Hierarchy

countries. These firms’ reinvestment decisions should therefore be affected to a larger extent by the strength of property rights. In contrast, in low-Embeddedness (Hierarchy) countries, firm

owners/managers are more willing to take risk (e.g., keep a high leverage ratio) and invest on a

larger scale, and hence their reinvestment decisions should depend to a larger extent on access to

external finance. We test these conjectures in Tables VIII and IX.

In Table VIII, we observe different effects of BANK_LOAN, which proxies for access to

external finance, and INFORMAL_PAYMENT, which proxies for the strength of property rights,

on profit reinvestment across cultures. In models 1 and 3, where the observations correspond to

high-Embeddedness and high-Hierarchy countries, respectively, INFORMAL_PAYMENT has a

significantly negative coefficient but BANK_LOAN has an insignificant coefficient. In contrast,

in models 2 and 4, where the observations correspond to low-Embeddedness and low-Hierarchy

countries, respectively, the coefficient on BANK_LOAN is significantly positive but that on

INFORMAL_PAYMENT is not significant. These results suggest that in high-Embeddedness

and -Hierarchy countries where people tend to avoid risk and pursue small-scale investment, firm

owners/managers may prefer that strong property rights be in place before they reinvest profit.

On the other hand, in low-Embeddedness and -Hierarchy countries where people tend to take risk

and engage in large-scale investment, availability of external financing is more important.

The results in Table VIII also show that private ownership and a larger firm size can moti-

vate firm owners/managers in high-Embeddedness and -Hierarchy countries to reinvest profits:

PRIVATE (LN_SIZE) has more significant (larger) coefficients in high-Embeddedness and -

Hierarchy countries. These results are consistent with the view that people in high-Embeddedness

and -Hierarchy countries have a lower motivation to invest. Private ownership is associated withhigher investment efficiency (Netter and Megginson, 2001) and large firms are less subject to

risk. Therefore, private ownership and firm size should make more of a difference among firms

in high-Embeddedness/Hierarchy countries characterizing by a lower motivation to invest.

Small firms in emerging markets are subject to severe financing needs and thus a good measure

of the motivation to invest is whether a firm reinvests all its profit. In Table IX, we repeat the

analyses in Table VIII using a logit model. The dependent variable is REINVEST_ALL, a

dummy variable that equals one if a firm reinvests all of its profit and zero otherwise. The

results have the same pattern as in Table VIII: INFORMAL_PAYMENT (BANK_LOAN) is

negatively (positively) associated with a firm reinvesting 100% of its profit only in high (low)-

Embeddedness/Hierarchy countries.

The above findings shed light on the recent debate over which formal institution—propertyrights or external financing—is more important. Our results suggest that the relative importance

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Table IX. Effects of the Access to External Finance and the Strength of PropertyRights across Cultures: Alternative Dependent Variable

This table presents results from logit models for high/low-EMBEDDED and -HIERARCHY countries.

The dependent variable is REINVEST_ALL, a dummy variable that equals one if a firm reinvests all of its profit and zero otherwise. EMBEDDED and HIERARCHY are national culture scores from Schwartz

(1994). PRIVATE is a dummy variable equal to one if the firm has shares held by private interests and zerootherwise. BANK_LOAN is a dummy variable equal to one if the firm has one or more bank loan(s) and zero

otherwise. INFORMAL_PAYMENT is total gifts or informal payments to public officials as a percentage

of total sales. JUDICIAL_ENFORCEMENT is the manager’s response to “On a scale of 1–6 (fully disagreeto fully agree), I am confident that the judicial system will enforce my contractual and property rights in

business disputes.” LN_AGE is the natural logarithm of the number of years the firm has operated in the

country. LN_SIZE is the natural logarithm of the number of permanent and temporary employees of thefirm during the previous survey year. EXPORTER is the percentage of sales exported directly or indirectly.

Country/industry dummies and intercepts are also included in the regressions but not reported for brevity.Robust standard errors adjusted for country-level clustering are reported in parentheses. The variables in

bold face are the ones of interest.(1) (2) (3) (4)

High Low High LowEMBEDDED EMBEDDED HIERARCHY HIERARCHY

Firm-Level Firm-Level Firm-Level Firm-LevelDeviations Deviations Deviations Deviations

PRIVATE 0.06 0.01 0.19 –0.10(0.29) (0.40) (0.30) (0.39)

BANK_LOAN –0.02 0.37∗∗∗ –0.03 0.38∗∗∗

(0.17) (0.11) (0.17) (0.11)

INFORMAL_PAYMENT –0.05∗∗∗ 0.01 –0.05∗∗∗ 0.01

(0.02) (0.01) (0.02) (0.01)

JUDICIAL_ENFORCEMENT –0.08∗∗ –0.05 –0.07∗∗ –0.06

(0.04) (0.04) (0.03) (0.04)

LN_AGE –0.08 –0.04 –0.06 –0.04(0.11) (0.07) (0.11) (0.07)

LN_SIZE 0.17∗∗∗ 0.04∗ 0.16∗∗∗ 0.05∗

(0.06) (0.03) (0.06) (0.03)EXPORTER 0.32∗∗ 0.05 0.24∗ 0.10

(0.13) (0.13) (0.15) (0.13)Industry, country dummies/intercept Yes Yes Yes Yes

N of countries 11 11 11 11

N of observations 2,847 2,905 3,097 2,655


with cultural values associated with a high motivation to take risk, policies that focus on increasing

the availability of external financing are more important.

VI. Conclusion

In this paper, we examine the relationship between national culture—an important informalinstitution—and profit reinvestment by small firms in emerging markets, where formalinstitutions

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are largely underdeveloped. We find that Schwartz’s (1994) cultural dimensions Embeddedness

and Hierarchy are associated with lower profit reinvestment, suggesting that these two cultural

dimensions are associated with a lower motivation to invest. At the same time, most of the formal

institutions that we consider do not have a significant effect on reinvestment in our analyses,

suggesting that the effect of culture comes mostly from a direct channel and culture matters morefor emerging markets with weak institutional development.

Furthermore, we show that the strength of property rights, private ownership, and firm size

are more important in high-Embeddedness and -Hierarchy countries, whereas access to external

financingis more important in low-Embeddedness and -Hierarchy countries. Theseresults suggest

that policymakers in emerging markets interested in increasing economic growth by incentivizing

small businesses to reinvest profit should design such incentives according to their country’s

cultural profile.

In comparison to previous literature on culture and finance, our results show that culture con-

tinues to have a strong effect on the investment motivation of small firms. This helps explain

why different countries’ economies grew at different speeds in the early stages of their develop-

ment: cultural values played an important role in firm-level investment when formal institutions

were weak. Researchers had long ago conjectured, and more recently observed, a correlation

between informal institutions and economic development (Weber, 1905; Hofstede, 2001); this

study provides empirical evidence of such a link.

Appendix: Variables

Variables Definition Source

Panel A. Dependent Variables

REINVEST Reported percentage of profitreinvestment.

Enterprise Surveys

INTERNAL FINANCE Percentage of new investment financed

by internal funds.

As above

BANK FINANCE Percentage of new investment financed

by local and foreign banks.

As above

CREDIT FINANCE Percentage of new investment financed by trade credit.

As above

INFORMAL FINANCE Percentage of new investment financed by informal sources, such as family

members, friends, or informal money

lenders.

As above

REINVEST ALL Dummy variable equal to one if a f irm

reinvests all of its profit and zerootherwise.

As above

Panel B. Culture Variables

EMBEDDED Cultural dimension characterizing the

relationship between the individualand the group.

Schwartz (1994)

(Continued )

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HIERARCHY Cultural dimension characterizing asociety’s view about the distribution

of power and resources.

As above

HARMONY Cultural dimension characterizing the

relation between humankind and the

natural and social world.

As above

Panel C. Control Variables

LN GDP The natural logarithm of a country’s

GDP per capita in 2000 US$.

World Development

IndicatorsPRIVATE Dummy variable equal to one if the

firm has shares held by private

interests and zero otherwise.

Enterprise Surveys

BANK LOAN Dummy variable equal to one if the

firm has one or more bank loan(s)and zero otherwise.

As above

INFORMAL PAYMENT Total gifts or informal payments to

public officials as a percentage of total sales.

As above

JUDICIAL ENFORCEMENT The manager’s response to “On a scaleof 1–6 (fully disagree to fully agree),

I am confident that the judicial

system will enforce my contractualand property rights in business

disputes.”

As above

LN AGE The natural logarithm of the number of

years the firm has operated in the

country.

As above

LN SIZE The natural logarithm of the number of

permanent and temporary employeesof the firm during the previous

survey year.

As above

EXPORTER The percentage of sales exported directly or indirectly.

As above

Panel D. Additional Control Variables

POLITICAL RIGHTS A political rights score. We multiplyscores by –1 so that higher scores

indicate stronger political rights.

Freedom House

ECONOMIC FREEDOM A composite index that considersgovernment intervention, fiscal and

monetary policies, the ease of international investment and trade,

how wages and prices are

determined, property rights protection, and informal markets. We

multiply original scores by –1 so thathigher scores indicate more

economic freedom.

Heritage Foundation

(Continued )

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TRANSITION A dummy variable that indicateswhether a country is transitioning

from a planned economy to a marketeconomy.

MUSLIM A dummy variable equal to one if the

country’s dominant religion in 2000is Islam and zero otherwise.

McCleary and Barro

(2006)

CATHOLIC A dummy variable equal to one if thecountry’s dominant religion in 2000

is Catholic and zero otherwise.

As above

ORTHODOX A dummy variable equal to one if thecountry’s dominant religion in 2000

is Orthodox Christianity and zero

otherwise.

As above

TRUST The percentage of a country’srespondents that believe people in thecountry are generally trustworthy.

World Values Surveys

ANTI DIRECTOR Revised antidirector index. Djankov et al. (2008)CREDITOR RIGHTS Creditor protection index. Djankov, McLiesh, and

Shleifer (2007)

CREDIT MARKET Total value of private credit scaled byGDP.

World DevelopmentIndicators

STOCK MARKET Total value traded in the stock market

scaled by GDP.

As above

Panel E. Instrumental Variables

Religious Composition Respective proportions of a country’s

population that claim to be Catholic(CATHOLIC%), Orthodox

(ORTHODOX%), Muslim(MUSLIM%), and Atheist

(NO RELIGION%) in 1900.

McCleary and Barro

(2006)

FRACTIONALIZATION Herfindahl index of a country’sreligious groups in 1900.

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