Political Connections and Business Strategy: The Impact of Types and Destinations of Political Ties on Business Diversification in Closed and Open Political Economic

Abstract

This paper studies how different types and destinations of connections between business leaders and political actors create strategic benefits in closed and open political economic systems. The analysis examines how political ties facilitate diversification by business groups in Taiwan between 1986 and 1998, before and after the country underwent extensive political and economic liberalization that led to changes in diffusion of power, tie accountability, and public scrutiny. We show that formal position interlocks with the dominant party or senior government officials provide the greatest strategic benefits in a closed political economic system, while informal social ties to a wider range of political actors provide greater strategic benefits when a political economic system becomes more open.

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Political Connections and Business Strategy: The Impact of Types and Destinations of
Political Ties on Business Diversification in Closed and Open Political Economic
Contexts


Chi-Nien Chung
National University of Singapore Business School
1 Business Link, Singapore 117592
Phone: (65) 6874-6885 email: bizccn@nus.edu.sg

Ishtiaq Mahmood
National University of Singapore Business School
1 Business Link, Singapore 117592
Phone: (65) 6874-6387 email: bizipm@nus.edu.sg

Will Mitchell *
The Fuqua School of Business, Duke University
Box 91020, Durham, NC 27708-0120
Phone: 919.660.7994, Fax: 919.681.6244, Email: Will.Mitchell@duke.edu


November 2, 2007


* Will Mitchell is the corresponding author

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Political Connections and Business Strategy: The Impact of Types and Destinations of
Political Ties on Business Diversification in Closed and Open Political Economic
Contexts


ABSTRACT
This paper studies how different types and destinations of connections between business
leaders and political actors create strategic benefits in closed and open political economic
systems. The analysis examines how political ties facilitate diversification by business groups
in Taiwan between 1986 and 1998, before and after the country underwent extensive political
and economic liberalization that led to changes in diffusion of power, tie accountability, and
public scrutiny. We show that formal position interlocks with the dominant party or senior
government officials provide the greatest strategic benefits in a closed political economic
system, while informal social ties to a wider range of political actors provide greater strategic
benefits when a political economic system becomes more open.

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The political connections literature typically argues that firms with political ties gain
strategic benefits such as regulatory favors and investment resources (Fisman, 2001; Faccio,
2006). However, the existing literature has three gaps. First, although the literature sometimes
distinguishes between different types and destinations of political ties (Johnson and Mitton,
2003; Leuz and Oberholzer-Gee, 2006), studies typically do not discuss how different types
and destinations of ties will have different impacts in different political economic contexts.
Second, the literature historically focused on descriptive arguments and/or industry and
country studies (Bauer, Pool and Dexter, 1972; MacIntyre, 1994; Evans, 1995; Schneider,
1998; Wank, 2002), only recently beginning to examine the impact of connections between
individual business leaders and political actors (e.g., Faccio, 2006; Siegel, 2007). Third, the
literature most commonly focuses on business performance, with only limited examination of
firms' underlying business strategies. This paper addresses these gaps by studying business
diversification strategy in an emerging market economy, arguing that the relative strategic
benefits of formal position interlocks and informal social ties to dominant political parties,
government officials, and legislators change as a closed political economic context becomes
more open.
Political connections are linkages between individual business leaders and political
actors such as party leaders, senior government officials, and elected legislators (Fisman,
2001; Siegel, 2007). This definition reflects the idea in the social networks literature that
interpersonal linkages can serve as conduits of resources and influence (Coleman, 1988;
Granovetter, 1985), while recognizing the differences in destinations of ties driven by the
heterogeneity of political actors (Lin, Vaughn, and Ensel, 1981; Knoke, 1990). Political ties
may involve formal position interlocks in which business leaders serve as political actors
(Faccio, 2006), or may involve informal social linkages between corporate leaders and
friends, family, or classmates who hold political posts (Bertrand, Kramarz, Schoar, and
Thesmar, 2004; Siegel, 2007). Political ties commonly create strategic benefits for connected

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firms, where strategic benefits are resources that a firm can use to facilitate its business
activities.
We argue that the strategic benefits of different types and destinations of political ties
will vary in open and closed political economic systems, where open and closed systems
differ in the extent of political and market liberalization that a country has undergone at a
given time. We predict that formal position interlocks to political actors with direct influence
on resource allocation, such as party leaders and senior government officials, will be
particularly beneficial for business diversification in closed political economic systems, but
that the benefits will decline as a political economic system becomes more open. In parallel,
we argue that informal social ties to a wider range of political actors (including political
actors with more indirect influence on resource allocation, such as elected legislators) will
offer increasing benefits for business diversification as a political economic system becomes
more open. The differences arise because of differences in tie accountability, diffusion of
power, and public scrutiny in different political economic contexts.
The empirical analysis focuses on diversification by the 100 largest business groups in
Taiwan between 1986 and 1998, before and during a period when the country underwent
extensive economic and political liberalization. Business groups are firms that operate in
multiple industries, which are linked to each other through financial, managerial, and
operating interlocks (Granovetter, 2005; Khanna and Yafeh, 2007). The flagship firms in
many industries in emerging economies are members of business groups, which collectively
produce significant portions of national GDP and influence the direction of national
development through their expansion choices (Khanna, 2000; Fisman and Khanna, 2004;
Granovetter, 1995). Diversification by business groups is an important strategic activity that
has a major impact on economic development in their countries. At the same time, group
owners and business executives commonly have strong ties with political actors in their
countries (Morck, Wolfenzon, and Yeung, 2005). This research design allows us to focus on

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the impact of political ties on diversification strategy at different stages of political economic
development within a country, thereby providing insights that are relevant to many countries
that are undergoing structural changes in political and market institutions (Huntington, 1991;
Sachs and Warner, 1995).
THEORETICAL BACKGROUND
The Significance of Business Diversification in Emerging Economies
Diversification is an important element of business strategy, with impact on both
corporate evolution and social welfare. Firms diversify into new product markets for multiple
reasons, including extending existing resources (Penrose, 1959; Montgomery, 1994), market
expansion (Rumelt, 1974; Wernerfelt, 1984), and managerial empire building (Jensen and
Meckling, 1976). Diversification – whether related or unrelated – can either improve or
damage corporate performance in both developed (Montgomery and Singh, 1984) and
developing economies (Khanna and Rivkin, 2001).
Beyond the corporate level, diversification by multi-business firms plays an important
role in the mobilization and distribution of resources throughout a country, particularly during
developmental stages. Economic theory and data show that the process of industrialization
often causes developing countries to first broaden their industrial production base in order to
mobilize resources, diversify risk, and provide greater consumption opportunities before the
countries eventually specialize in order to take advantage of economies of scale (Acemoglu
and Zilbibotti, 1997; Imbs and Wacziarg, 2003). Whereas industrial transformation in
developed market economies is often led by new entrants (Mansfield, 1996), the absence of
well-developed market institutions in many emerging economies implies that established
firms are the primary actors with infrastructure available to mobilize financial, technical, and
managerial resources needed to expand the industrial base in an emerging market (Khanna
and Palepu, 1999). Hence, firm diversification often contributes to economic development in
emerging economies (Leff, 1978; Amsden, 2001). Examples include Germany and England