Michael Keefe explains why entrepreneurs and firms that have a high chance of succeeding tend not to connect with politicians

By Michael O'Connor Keefe*

This note provides excerpts and summarises “A theory of political connections and financial outcomes,” which is forthcoming in the International Review of Economics & Finance.1

Ideally, a financial system allocates capital to projects that in expectation return the risk adjusted cost of capital, leading to investment in projects that provide return over a long periods of time (i.e. these projects are sustainable). 

Further, by definition these high returning projects must innovate in technology or process and fulfill an unmet market need.

Governments play a large role in the financial system.  Some of these roles include the state ownership of banks, private property protections, bank governance, and policy incentives.  There are a copious empirical studies (but almost no theoretical models) about the relationship between political connections and finance.  These studies clearly explain what happens in politically connected setting, but not why.

This often leads to contradictory empirical evidence.   For example, Bliss and Gul (2012) advance that political connections in Malaysia increase interest rates, Infante and Piazza (2014) suggest that political connections in Italy decrease interest rates, and Khwaja and Mian (2005) find no evidence political connections in Pakistan affect interest rates.

To explain why we might see different relationships between political connections and financial outcomes, I extend the models of Holmstrom and Tirole (1997) and Tirole (2006, pages 535-540).  The model explains many apparently conflicting empirical results relating to the influence of political connections on loan interest and default rates, access to credit, the co-existence of politically connected and unconnected borrowers, and the combination of low-returns and over-investment in politically connected firms.

The model explores three channels of political influence. The first channel is through political influence over contract enforcement. Following Tirole (2006, pages 535-540), I model uncertain contract enforcement. In Tirole’s model, the lender adjusts the contract between the lender and borrower to account for the possible lack of enforcement.

This adjustment increases the interest rate (relative to the case with perfect enforcement), but the expected rate of return on the loan is unchanged. 

The second channel is through political influence over lender compensation. The model shows that political influence through this channel decreases loan interest rates. Taking the channels of contract enforcement and lender compensation together, the model shows that the loan interest rate increases as the probability of contract enforcement decreases, but decreases with political influence over lender compensation. Thus, the effects from expropriation risk and political influence over lender compensation counteract each other; implying a plausible negative, positive, or zero net effect of political connections on the interest rate of a loan. For example, in Italy, where the main channel of political connections is through influence over lender compensation, the model implies political connections decrease loan interest rates, which matches the findings of Infante and Piazza (2014). Alternatively, in Pakistan political connections influence both contract enforcement and lender compensation. In this case, the model shows that these two channels may counteract each other, which is consistent with Khwaja and Mian (2005) finding that political connections do not affect loan interest rates. Taken together, the different channels of political connections help explain the contradictory empirical evidence about the relationship between political connections and loan interest rates.

A third channel of political connections is through the possible requirement of the manager to contribute to social objectives (e.g. employ greater than an optimal number of employees) on behalf of the state. The diversion of firm resources to social objectives is costly to the manager. To incentivise the manager, the state provides implicit compensation (e.g. future promotions). Thus, the gain (or loss) to the manager is the difference between the implicit compensation and costs associated with the social objectives. If this difference is positive, the manager always chooses to become politically connected. If the difference is negative, then the manager factors these costs into her decision about whether to become politically connected. Likewise, the model shows why the lender is concerned about political connections. First, a lender understands that a politically connected borrower diverts a portion of the project return to social objectives, which decreases the return available to repay the loan. Second, the cost of social objectives decreases the motivation of the borrower to work hard, which increases the cash required to remain incentive compatible. From this perspective the manager might choose to be politically unconnected to loosen credit constraints. Overall, the co-existence of political connected and unconnected borrowers in the same economy can be interpreted as borrowers choosing to be politically unconnected to capture the economic rents of high return projects.

The idea that a manager faces a choice regarding whether to become politically connected tends to be overlooked in the empirical literature on political connections. Without directly modeling the manager’s choice, the literature often reaches apparently contradictory conclusions. For example, Faccio (2006) finds a positive abnormal return due to firm announcements of becoming politically connected. In contrast, Fan, Wong, and Zhang (2007) show that politically unconnected IPO firms in China outperform politically connected IPO firms using a wide variety of three-year measures including use post-IPO stock return, earning growth, sales growth, and return on sales. However, both studies are consistent with managers making optimal choices and more specifically managers with high return projects choosing to be politically unconnected.

The manager chooses the investment level. Clearly, if the manager chooses to be politically unconnected, then political connections do not affect the investment decision. In this case, the manager’s objective does not include the value of political connections, which implies the expected NPV to the manager is equal to the expected project NPV. In contrast, if the manager chooses to be politically connected, she increases investment relative to the politically unconnected case, which leads to over-investment. The model implications are borne out in the empirical literature. For example, Chen, Sun, Tang, and Wu (2011) show that non-SOEs (State Owned Enterprises) in China have higher investment efficiency than SOEs. In addition, Wei and Zhu (2015) report that state owned firms (relative to private firms) have lower returns on equity. At an aggregate level, Khwaja and Mian (2005) estimate investment distortion from political loans at between 0.8-1.6 percent of GDP each year.

In the model, the manager chooses whether to become politically connected. This choice mirrors Deng Xiaoping “Cat Theory” which states: “It doesn’t matter if a cat is black (planned) or white (market); as long as it catches mice, it’s a good cat” (Di, 2016). In practice, the manager’s decision is influenced by the political and economic freedoms allowed by the state. For example, Horwitz (2017) reports that Jack Ma supports the CCP but attempts to distance himself from the state. Horwitz (2017) writes,

In a 2015 interview at Davos, Ma discussed how he once worked at a Chinese state-owned enterprise, which led him to tell early Alibaba employees they should be “in love with the government [but] don‘t marry them.” Normally, when the government comes and says “Jack, can you do this project?,” I say no.

Horwitz (2017) also writes,

The party sees tech as a vehicle for economic transformation, as well as to monitor society and maintain stability. But tech is also something to control, particularly when it comes to expression online, and there has been talk of the government taking stakes in technology companies. All of that makes for a tricky environment for founders to navigate, particularly those seeking an amicable relationship, but not marriage.

In the current political climate, Jack Ma’s political decisions are more complicated than the Deng Xiaoping’s “Cat Theory” would suggest. Overall, the model takes a step toward modeling the choice of becoming politically connected, but doesn’t fully capture the complexities of the decision; however, Jack’s political philosophy is consistent the model’s prediction that firms with high success probabilities choose to be politically unconnected.


1. See https://www.sciencedirect.com/science/article/pii/S1059056017305865  for a copy of the journal article.  For a limited period of time,  Elsevier is  providing the article free of charge at https://authors.elsevier.com/a/1YZpa3mpInjN49.


Bliss, M. A., Gul, F. A., 2012. Political connection and cost of debt: Some Malaysian evidence. Journal of Banking & Finance 36 (5), 1520–1527.

Chen, S., Sun, Z., Tang, S., Wu, D., 2011. Government intervention and investment efficiency: Evidence from china. Journal of Corporate Finance 17 (2), 259–271.

Di, F., 2016. Reflecting on Deng Xiaoping‘s ‘cat theory’ of economic reform. The Epoch Times 2018 (04/02), 1–5.

Faccio, M., 2006. Politically connected firms. The American Economic Review 96 (1), 369–386.

Fan, J. P. H., Wong, T. J., Zhang, T., 2007. Politically connected CEOs, corporate gover- nance, and Post-IPO performance of China’s newly partially privatized firms. Journal of Financial Economics 84 (2), 330–357.

Holmstrom, B., Tirole, J., 1997. Financial intermediation, loanable funds, and the real sector.

The Quarterly Journal of Economics 112 (3), 663–691.

Horwitz, J., 2017. Jack Ma has some thoughts on China’s “clean” communism and the US’s divided politics. Quartz 2018 (04/02), 1–3.

Infante, L., Piazza, M., 2014. Political connections and preferential lending at local level: Some evidence from the italian credit market. Journal of Corporate Finance 29, 246–262.

Khwaja, A. I., Mian, A., 2005. Do lenders favor politically connected firms? Rent provision in an emerging financial market. The Quarterly Journal of Economics 120 (4), 1371–1411.

Tirole, J., 2006. The Theory of Corporate Finance, 1st Edition. Princeton University Press, Princeton, New Jersey.

Wei, L., Zhu, G., Sept. 13 2015. China unveils overhaul of bloated state sector: Beijing to allow state-owned enterprises to add private investors. Wall Street Journal Online.

Michael O’Connor Keefe is Senior Lecturer at Victoria University of Wellington School of Economics and Finance. You can contact him here.

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