International Research Journal of Finance and Economics

ISSN 1450-2887 Issue 8 (2007)

© EuroJournals Publishing, Inc. 2007
http://www.eurojournals.com/finance.htm

Trends and Determinants of Mergers and Acquisitions in

Developing Countries in the 1990s

Ahmed Kamaly
Department of Economics, The American University in Cairo
113 Kasr El Aini P.O. Box 2511, 11511 Cairo, Egypt
Email: kamaly@aucegypt.edu

Abstract

This study sheds some light on the direction and determinants of the aggregate
Mergers and Acquisitions (M&A) activity directed to developing countries in the 1990s
using a dataset obtained from the SDC Platinum Worldwide Mergers and Acquisitions
Databases. The study adopts a dynamic panel data model to gauge the macroeconomic
determinants of aggregate M&A. Results indicate that M&A activity embodies a moderate
level of inertia, though much less than the one previously estimated for total FDI. A
decrease in the international interest rate or an increase in S&P 500 index positively affect
M&A indicating the procyclical nature of M&A directed to developing countries.
Openness has a significant effect on M&A, but quantitatively its effect is minimal.
Depreciation in the domestic exchange rate strongly and positively affects M&A. This
result could explain the apparent stability of aggregate FDI even in face of financial
turmoil. Finally and interestingly, higher level of stock market activity and depth in
developing countries decrease the amount of M&A directed to them.

Keywords: Mergers and Acquisitions, Foreign Direct Investment, Dynamic Panel Models,
Developing Countries
JEL Classification: C23, G15, F23, F32, C52

I. Introduction
Until recently, mergers and acquisitions (M&A) activity was an insignificant part of capital flows to
developing countries. It was not until the recent surge in capital flows, and the dominance of foreign
direct investment (FDI) in the 1990s, that economists started to take a closer look at M&A. However,
such a “look” has often been restricted to a simple reporting of the share of M&A activity in total FDI
and its growth over time. However, the growing share of FDI in total capital flows directed to
developing countries, coupled with the increase in the share of M&A in FDI flows, should have incited
economists to study more carefully the behavior as well as the determinants of such activity.
Surprisingly enough, the existing literature focusing on the aggregate M&A activity in developing
countries is almost nonexistent1. There are several reasons for this, most of which are related to the
availability of data and the way M&A are reported and organized.
This paper aims at filling the gap in the literature by empirically examining the determinants of
aggregate M&A activity to developing countries in the 1990s using the SDC Platinum Worldwide
Mergers and Acquisitions Database. In addition, by drawing on the literature pertaining to the

1
A notable exception is the study by Aguiar and Gopinath (2005).
17 International Research Journal of Finance and Economics - Issue 8 (2007)

determinants of FDI, this study offers a more comprehensive and accurate account of the forces
shaping the two components of FDI: greenfield investment and M&A. A number of studies have
examined the determinants of FDI in the 1990s. However, a number of questions have remained
unanswered. This study should be regarded as another step toward unraveling some of these questions.
More specifically, dissecting FDI and looking into one of its ingredients provides valuable insights on
how internal and external factors affect M&A, greenfield investment, and ultimately FDI.
This study is organized as follows. Section two reviews some background literature. Section
three discusses the data, the model, and the estimation procedure. Section four presents and analyzes
the results, their implications, and their significance. Finally, section five offers concluding remarks.

II. Background Literature

The literature on M&A has roots in both financial economics and macroeconomics. If the focus is on
the individual firm, then one has to rely on capital budgeting, information asymmetry, and other areas
of corporate finance to explain a firm’s decision to acquire another. On the other hand, if the focus is
to explain the “aggregate” behavior of M&A activity, then one has to concentrate on broad
macroeconomic and financial indicators used to explain aggregate variables, such as investment.
Nevertheless, it is possible that only micro data on M&A produces meaningful empirical results,
whereas aggregate M&A activity is just a random variable with no distinct behavioral relation.
Shughart and Tollison (1984), using annual U.S data and univariate analysis, found that the aggregate
merger level is a white-noise process. However, they emphasized that such a result should not be
viewed as evidence against the existence of external determinants of aggregate M&A. Indeed, almost
all empirical studies that have examined aggregate M&A activity have found evidence that variables
such as the cost of capital, stock prices, and measures of aggregate activity significantly influence
M&A activity.
Table 1 summarizes the dated empirical literature on aggregate M&A. From this table, one
could note the following: First, the data sets used in almost all of these studies are more or less
variations of Nelson’s (1959) original dataset which defines M&A as the number of U.S mergers in
manufacturing and mining with acquired firm assets of at least one million dollars. A few studies have
extended the original period, 1895-1955, up to 1979 (Clark et al., 1988a,b; Benzing, 1991; and
Benzing, 1992). The last study appearing in this table, Benzing (1993), used another dataset, the
Grimm & Co. dataset, covering the period 1964-1986. Second, all of the studies that included stock
prices, with the exception of Benzing (1993), reported its positive significant effect on M&A.
This result is in line with the expectation hypothesis (Nelson, 1966) and economic disturbance
theory (Gort, 1969). According to the former hypothesis, positive expectations about future,
manifested by strong economic growth and high stock prices, are conducive to mergers. When stock
prices are buoyant, the cost of capital is reduced and the value of the potential acquired firm rises,
making the merger more desirable. Economic booms in turn have two effects that encourage M&A
activity. First, the value of the firm usually appreciates as a result of dynamic sales potential. Second,
production capacity often falls short of increasing demand, driving firms to acquire others in order to
cover this gap. Gort (1969), on the other hand, argued in his economic disturbance theory that during
periods of high stock prices, there is greater potential for differences in the valuation of stocks between
buyers and sellers, which is a catalyst for mergers.
International Research Journal of Finance and Economics - Issue 8 (2007) 18
Table 1:

Study Sample used Stock Interest Industrial Unempl Notes

Price rate Production oyment
Nelson (1959) Number of US mergers in + +
manufacturing and mining
with acquired firm assets of
at least $1 million over
1895-1956 period
Weston (1961) Inter-war period + A Multiple regression
analysis was used.
Nelson (1966) Same as Nelson (1953) but +
over 1919-61 period
Melicher et al Same as Nelson (1959) but + - A Cross correlation and
(1983) over the 1947-77 period multiple regression
analysis were used
Shughart and Same as Nelson (1953) but This analysis used number
Tollison extending the end date to of mergers, nominal
(1984) 1979. Data for the 1947-79 merger values, and real
period is for acquired firm merger values. Evidence
with assets ≥ $ 10 million. for random walk and
AR(1)
Polonchek and Same restriction as + - A2 - Multiple regression
Sushka (1987) Shughart and Tollison analysis was used but
(1984) but for 1956-77 lagged dependent was not
period. included.
Clark el al. Same as Nelson (1959) but Results indicated that
(1988a) changing the period to mergers activity (i)
1919-79. exhibits no deterministic
trend but there exists a
stochastic pattern; (ii) is
not a random process; and
(iii) follows an AR(2)
process.
Clark el al. Same as Clark el al. + A M&A activity follows an
(1988b) (1988a) AR(2) process.
Benzing Same as Clark el al. + -3 A AR(2) specification. Signs
(1991) (1988a) of variables depend on the
period examined.
Benzing Same as Clark el al. + - - AR(2) combined with
(1992) (1988a) deterministic trend
specification
Benzing Grimm & Co. data set A A - AR(2) specification
(1993) covering 1964-86 period.
+ and – signs denote positive and negative effect on M&A. Whereas “A” symbolizes that the corresponding variable has an ambiguous effect on M&A

Another observation pertaining to Table 1 is the significance of the interest rate in most studies.
One could think of different ways by which interest rates could affect merger activity. Perhaps the
most direct way is through its effect on the cost of capital. A high interest rate raises the cost of capital
which in turn, lowers the level of investment and the attractiveness of mergers between firms4. The
literature often refers to this channel as capital market condition (see for example Melicher et al., 1983
and Benzing, 1991). A less direct way by which interest rate could affect M&A is through credit
channel. Raising the interest rate leads to credit crunch making financial intermediaries reluctant to
finance merger deals. Note that it is quite difficult to draw a distinct line between the expectation

2
Change in capacity was used as a proxy for economic condition. Failure rate was also included in the regression, and it was found to have a negative
effect on M&A.
3
For the whole period, the sign of the interest rate was found to be negative; however, the sign turned out to be positive prior to 1950.
4
One of the primary explanations of M&A is the existence of investment opportunities outside the firm. This explanation treats M&A as an external
investment, as opposed to the usual internal one.
19 International Research Journal of Finance and Economics - Issue 8 (2007)

hypothesis and the capital market condition hypothesis, since any change in interest rates could be
transmitted to movements in the stock prices.
The last comment concerns the empirical methodology used in these studies. All studies have
used cross correlations and/or simple OLS to analyze M&A. It was not until Clark el al. (1988a) that
studies recognized the importance of including lagged dependent variables in the regressions. As for
explanatory variables, all of these studies have used current values without attempting to correct for
possible endogeneity problems.
More recently, di Giovanni (2005) using the same database used in this study has provided
empirical evidence on the positive and significant effect of financial market deepening in the
acquisitions countries on M&A activity. di Giovanni sample consists of a mix of developed and
developing countries; however, splitting the sample to developing and developed countries did not
appear to change the main result of the study.
The literature on the empirical determinants of M&A directed to developing countries is almost
nonexistent. The only study that focuses on M&A directed to emerging markets is the study by Aguiar
and Gopinath (2005). Aguiar and Gopinath develop a corporate finance-based theoretical model with
testable predictions. Using firm-level data for five East Asian countries over the period 1981-2001, the
authors verify that the liquidity crunch, faced by domestic firms as a result of the East Asia crisis,
increased M&A activity. Other studies such as World Bank Global Development Finance that deal
with capital flows, report M&A directed to developing countries as an aggregate percentage of FDI
without analyzing the factors shaping its movement.

III. Data, Model, and Estimation Procedure

A. Data Description and Trend
The main problem hampering the advancement of the empirical literature on M&A is data availability.
This explains the limited number of existing studies that deal with this important issue, and their sole
focus on the U.S. This study makes use of a relatively new data source: The SDC Platinum Worldwide
Mergers and Acquisitions Database. This database is quite comprehensive as it records actual and
potential M&A transactions worldwide. Each record of a transaction usually includes general
information about the two sides of the transaction, such as the country, primary SIC code, and balance
sheet information as well as general information about the deal such as the value, effective date, and
percentage acquired from the target firm.
In this study, I focus only on completed transactions5 in which the target nation is a developing
country with population greater than one million. Some observations are dropped from the sample due
to the unavailability of values for these transactions6. Hence, one should expect that the total value of
M&A calculated from this database is biased downwards. The data obtained from this database covers
approximately 60 developing countries from 1990 till 1999. However, not every country has
observations spanning over the whole period.
By aggregating the values of all these transactions according to the previous criteria, one can
get the total value of M&A for each year for different developing countries. Figure 1 depicts the total
value of M&A to sample developing countries over the 1990s. One can easily discern the strong
upward trend of M&A during the 1990s, which tracks more or less the trend of FDI. As shown in the
graph, M&A reaches its peak in 1998, before retracting a little bit in 1999. From 1993 till 1998,
aggregate M&A activity witnesses a seemingly exponential growth.

5
The criterion for a completed transaction is that it has an effective date.
6
As argued by di Giovanni (2005), the distribution and number of deals with no values appear random; hence one should not expect that the missing
values would bias the estimation results.
International Research Journal of Finance and Economics - Issue 8 (2007) 20
Figure 1:

The Trend of M&A over the 1990s

90000
80000
70000
60000
$ million

50000
Total M&A
40000
30000
20000
10000
0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
Year

Source: Compiled by the author

Figure 2 shows the composition of M&A over the 1990s. M&A transactions are grouped into
four categories according to the SIC code of the target company. These categories are: (i)
transportation, communication and public utilities; (ii) trade, finance, real estate, and insurance; (iii)
services, public administration, and construction; (iv) manufacturing and mining. A few comments are
in order. First, the share of trade and the financial sector in total M&A has been growing throughout
most of the 1990s. Interestingly, this share grows following both major financial crises of this period;
growing in 1995 following the Tequila crisis, and in 1998 following the Asian crisis. Second, on
average, the share of manufacturing and mining declines over the sample period, and seems to shrink
right after major financial and currency crises. Third, the total share of the tradable sector has been
shriveling over the sample period relative to nontradable sector. Again, this movement appears to be
more pronounced right after major financial and currency crises.
21 International Research Journal of Finance and Economics - Issue 8 (2007)
Figure 2:

100%

80%
Transportation, Comm & Public
utilities
60% Trade, Finance, Real estate &
Insurance
Services, Public adm. &
40% Construction
Manufacturing & Mining

20%

0%
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Source: Compiled by the author

A couple of reasons could be offered to explain these changes in the composition of M&A
activity and their apparent sensitivity to financial and currency crises. First, as countries develop, the
share of services and finance, which are a part of the nontradable sector, expand relative to the goods
sector, which are mostly tradable. This change in the composition of profitable investment
opportunities encourages foreign firms to increase their holdings of domestic assets belonging to the
nontradable sector. Second, in times of financial distress and currency crash, the tradable sector is
more able than the nontradable sector to weather the crisis. This is simply because, by definition,
companies operating in the tradable sector can turn to the rest of the world to exhaust the accumulated
production resulting from the fall in domestic demand. In fact, Lehmann (2002) finds that in Mexico
during the Tequila crisis, and in Korea, Thailand, Malaysia and Indonesia during the Asian crisis, the
revitalization in the export market and the rapid direction of sales away from depressed local markets
have eased, and in some cases, mitigated the huge drop in local sales; thus, helping these firms to avoid
bankruptcy and the liquidation of their assets.
Firms operating in the nontradable sector, on the other hand, are not as fortunate. The massive
drop in local demand coupled with credit rationing, which usually characterizes financial crises, take
their toll on nontradable sector firms pushing them toward liquidation and bankruptcy. This, coupled
with the collapse of the local currency, drives the market value of these firms to an abyss. To
multinational corporations, these bargains are not to be passed up! This situation leads to what is
known now in the literature as “Fire-sale” FDI (Krugman, 1998). This could explain the observed turn
in the composition of M&A toward the nontradable sector following the Tequila crisis of 1994 and the
Asian crisis of 19977.

B. Model
Following most of the empirical studies that attempt to examine the macro determinants of FDI, (see
for example Edwards, 1992; Calvo and Reinhart, 1998; Mercereau, 2005), this study adopts a reduced
7
This observation somewhat contradicts one of the findings of Aguiar and Gopinath (2005) where they find evidence that during crisis period, the effect of
liquidity on the probability of acquisition is stronger among firms operating in the tradable sector. One should note however, that the sample used in
Aguiar and Gopinath’s study is restricted to five East Asian countries.
International Research Journal of Finance and Economics - Issue 8 (2007) 22

form model. Nevertheless, the selection of the variables included in the model is not arbitrary but
rather guided by theory and other empirical studies as explained below. The model used in this study
is a dynamic panel model with a fixed-effects specification in the form of:
yit = α + µ i + δyit −1 + xit' β + uit (1)
u i ~ iid (0, σ )
2
u i = 1,2,...N , t = 1990,....1999
Where
y it : Total M&A to GDP ratio
xit' : The matrix of explanatory variables besides the lagged dependent variable
N: Total number of countries
µ i : Country individual effect
α , δ and β are unknown parameters
u it : Error term
It is assumed that the error term uit follows a one-way error component model with constant
variance σ u2 . The fixed-effects representation captures the idea that countries, in most cases, have
individual specific effects such as institutional settings, geographical characteristics, and cultural
norms, which influence M&A but could be regarded as fixed in the short and medium terms.
The endogenous variable in this model is taken to be the total M&A to GDP ratio. All the
studies appearing in Table 1 with the exception of Shughart and Tollison (1984) use the number of
mergers as the dependent variable. Using the value of M&A transactions is based on the perception
that a great deal of information is lost if one uses only the number of successful M&A. Using values
amounts to weighing each observation according to its size, while the number of transactions itself
provides no information about the absolute or relative flows of capital entering a particular country in
the form of M&A. I use the ratio of M&A to GDP instead of simply the aggregate value of M&A for
two reasons. First, to make sure that the endogenous variable is stationary; and second, to control for
the size of the target nation.
The list of explanatory variables besides the lagged dependent variable in the base regression
includes: the weighted average bond yield in the G7 countries, the lagged change in the S&P500 index,
and the ratio of the sum of imports and exports to GDP. The existing literature has clearly established
the first two variables as important determinants of M&A. Note that the interest rate measure includes
G7 countries not only the US interest rate. The rational is the following. Acquiring firms are usually
multinationals, so interest rates in industrialized countries not only in the US should play a role in
discounting the net flows of the acquired firm or calculating the cost of capital. The bond yield, on the
other hand, was chosen to reflect the fact that M&A activity is a long term commitment and the
revenue associated with it usually spread over a relatively long period of time.
The new variable to the M&A regressions is the ratio of the sum of imports and exports to
GDP. This is a common measure of openness of the economy. Many empirical studies, such as
Edwards (1992), Singh and Jun (1995), Bathattacharya, Montiel and Sharma (1997) and Kamaly
(2003) have confirmed the significance of this variable in driving FDI flows. Recently, di Giovanni
(2005) has found evidence for the complementarity between openness and M&A. Finally, I should
note that my regressors originally included real GDP growth, which was then dropped due to its
insignificance.

C. Estimation Procedure
The dynamic panel model used in this study calls for a special type of estimation to deal with the
problems generated by including the lagged dependent variable in the regression. In these models, if
the usual panel regression techniques, such as the Within estimator, are used the results could suffer
from inconsistency and bias, especially if the time dimension is small and the cross section dimension
23 International Research Journal of Finance and Economics - Issue 8 (2007)

is large, which is true in our case8. The recent development of dynamic panel models has provided a
number of solutions for this problem. Among the first suggested solutions is the one introduced by
Arellano and Bond (1991) which is often referred to in the literature as the GMM-IV or the standard
GMM estimator. This estimator makes use of the orthogonality conditions that exist between the
instruments and the model after some type of transformation (e.g. first differences or orthogonal
deviations).
This study, however, adopts another GMM estimation technique based on Arellano and Bover
(1995) and Blundell and Bond (1998), which builds and improves upon the standard GMM estimator.
In addition to the moment conditions associated with the standard GMM estimator, this estimator
employs additional restrictions based on the fact that any available instrument that is not correlated
with the group effects µ i can serve as an instrument for (1) in levels without any transformation.
Combining all these restrictions in one system and using GMM produces a more efficient estimator the
GMM-SYS estimator.
Despite the fact that efficiency is gained from additional moment restrictions, having “too
many” instruments per se is not desirable. Since the sample size is relatively small, a very large
number of instruments could result in a small sample bias (Kiviet 1995). This is why not all of the
available instruments were used in the regressions. Increasing the number of instruments did not
change the coefficients estimates much, but did raise the level of significance in a handful of them9.
The transformation used in the estimation is orthogonal deviations10 as opposed to first
differencing. The advantage of this transformation is that autocorrelation between transformed errors
will be absent if it is absent among the original errors. In fact, the orthogonal deviations procedure is
equivalent to first differencing to get rid of fixed effects, and then using GLS to eliminate first degree
autocorrelation resulting from first differencing (Arellano and Honoré, 2001).

IV. Empirical Results and Implications

This section presents and analyzes the results obtained from estimating (1) using the estimation
procedure outlined above. In all of the presented estimated equations, the GMM-SYS estimation
procedure was used along with the orthogonal deviations as the method of transformation11. Only the
two-step results are shown12; however the one-step results are almost identical.
First, a base regression was estimated with the lagged dependent variable, openness, the
weighted average bond yield, and the change in S&P500 as explanatory variables (see data appendix
for variable definitions). The results of this regression are shown in the second column of Table 2. As
apparent from the results, all the explanatory variables are significant at least at the 5% level, and carry
the expected signs. The Wald test indicates the joint significance of the explanatory variables. The
Sargan test confirms the validity of the imposed moment conditions. The first and second order tests
for autocorrelation of the transformed residuals point to the presence of first order negative serial
correlation and the absence of second order serial correlation, both of which indicate the absence of
serial correlation among the original errors u it . This last condition is a crucial one for the consistency
of the GMM-SYS estimator (Arellano and Bond 1991).

8
See Nickell (1981) and Anderson and Hsiao (1981) for more details.
9
Results of these regressions are available upon request.
10
This is a transformation introduced by Arellano (1988), and Arellano and Bover (1995) where each observation is transformed into a weighted
12
* ⎛ z i , t +1 + ... + z i ,T ⎞⎛ T − t ⎞
z it =
⎜⎜ z it −
⎟⎟⎜⎝ T − t + 1 ⎟⎠
deviation from the average of future observations for the same group: ⎝ T − t
t = 1,2,3..., T − 1 Note that this
⎠
transformation also standardizes the variance.
11
Estimates based on first differencing are quite similar to those based on orthogonal deviations; however, using orthogonal deviations has improved
precision.
12
Note that the two-step results are more efficient if errors are heteroskedastic.
International Research Journal of Finance and Economics - Issue 8 (2007) 24
Table 2: Results of Estimated Equations

Explanatory Variables Base Lagged Lagged Lagged Lagged Lagged

Regression Index of M2 to Total Value Market Change in
Exchange GDP of Stocks Capitalization Nominal
Rate traded to to GDP Exchange
Variability GDP Rate
Lagged M&A/GDP 0.318 0.280 0.290 0.160 0.123 0.284
(2.52)** (2.33)** (2.30)** (2.15)** (1.66)* (2.34)**
Openness 0.011 0.01 0.009 0.009 0.011 0.012
(3.62)*** (3.20)*** (1.89)* (2.19)** (2.28)** (3.39)***
Bond yield in G7 countries -0.103 -0.083 -0.109 -0.069 -0.065 -0.121
(-3.31)*** (-2.50)** (-3.10)*** (-2.21)** (-2.13)** (-3.55)***
Change in S&P500 0.027 0.026 0.026 0.038 0.036 0.028
(2.60)*** (2.78)*** (2.77)*** (3.35)*** (3.11)*** (2.51)**
Additional Regressor . -0.001 0.005 -0.006 -0.007 0.037
(-0.446) (0.548) (-2.15)** (-1.83)* (3.42)***
Number of observations 348 348 337 274 284 340
Number of countries 60 60 60 45 47 60
Wald χ 2 117.5*** 129.1*** 105.6*** 98.92*** 97.25*** 128.0***
Sargan’s overidentifying 56.95 54.42 53.76 35.50 37.76 57.64
test (P-Value) (0.997) (1.00) (1.00) (1.00) (1.00) (0.99)
A & B test of 1st order -2.634 -2.659 -2.600 -2.391 -2.494 -2.592
autocorrelation (P-Value) (0.00)*** (0.01)*** (0.01)*** (0.02)** (0.01)** (0.01)***
A & B test of 2nd order 1.258 1.154 1.354 1.136 0.596 1.105
autocorrelation (P-Value) (0.209) (0.248) (0.176) (0.256) (0.551) (0.269)
Notes: t-statistics are in brackets. *** Significant at 1% level or more, ** significant at 5% level or more, * significant at the 10% level or more.
The t-statistics of these estimates are based on robust standard errors, after correcting for small sample bias, as suggested by Windmeijer (2005).

Turning to the point estimates, one notices that inertia plays an important role in driving M&A
to developing countries. The coefficient of the lagged dependent variable is approximately 0.31, the
largest among all explanatory variables, implying that the long-term effects of other explanatory
variables are 1.5 times their short-term effects. This inertia is, however, much less than that found for
aggregate FDI, where the coefficient of the lagged dependent variable in GMM-SYS specifications is
found to be around 0.7 as reported in Kamaly (2003) and Amaya and Rowland (2004). It may be the
case that the other component of FDI- greenfield investment- is more sluggish than M&A. This result
is consistent with the natures of greenfield investment and M&A. One would normally expect that
new projects are completed over a relatively long period of time. M&A transactions, on the other hand,
are just a transfer of ownership of already existing operating projects from domestic control to foreign
hands.
The measure of openness, the ratio of sum of imports and exports to GDP, is found to be
statistically significant but with a little quantitative significance. Interestingly, the magnitude of this
coefficient (0.01) is almost identical to that reported for the same variable in Kamaly (2003) for FDI
flows. This points to the strong association between FDI with its components and the degree of
openness.
The interest rate coefficient is statistically significant, and its magnitude is found to be the
second largest among the included explanatory variables. According to the point estimate, a one
percent point increase (decrease) in the interest rate measure decreases (increases) the M&A to GDP
ratio by 0.1 percent in the short-term and by approximately 0.15 percent in the long-term. The
significance of this variable is in line with existing evidence on the effect of the interest rate on M&A
activity (See Table 1).
The last explanatory variable in the base regression is the change in the S&P500 index. As
depicted in Table 1, stock prices have a significant positive effect on M&A activity in the majority of
existing empirical studies. Similarly, the change in the S&P500 index has a positive significant effect
on aggregate M&A directed to developing countries. According to the point estimate, a one percent
25 International Research Journal of Finance and Economics - Issue 8 (2007)

increase in the S&P500 index raises the ratio of M&A to GDP by 0.02 percent. This is not a negligible
effect, since the S&P500 index could very well register a two-digit percentage change over a couple of
months. However, one has to recognize that the significance of stock prices in the base regression
implies something different than its significance in the studies summarized in Table 1. In the latter
case, both the M&A and stock prices refer to the U.S. In this study, however, the target companies are
developing countries’ firms, while stock prices correspond to the U.S. In this case, one cannot readily
apply the expectation hypothesis, since buoyant stock prices in the U.S do not necessary suggest
favorable economic conditions in developing countries. Nevertheless, the significance of the change in
the S&P500 index suggests that higher stock prices in the industrialized world13 have a positive
spillover on M&A activity directed to developing countries.
There are a couple of explanations that could be offered to account for this observed positive
relation between M&A activity in developing countries and the S&P 500. One is that high US stock
prices could be an indication of a present or future boom in the US (Fama, 1981). During such times,
additional capacity is often needed. A possible solution is to acquire firms from developing countries,
which can be obtained at a discounted price compared to the firms in industrialized countries. Another
possible explanation is a spillover effect. The high price of stocks in developed countries enables firms
to secure more funds for investment, part of which can be used to pursue external investment
opportunities such as M&A.
Next, the effects of some additional explanatory variables on M&A flows to developing
countries are examined. These variable are: the lagged index of exchange rate variability, the lagged
ratio of M2 to GDP, the lagged ratio of the total value of domestic stocks traded to GDP, the lagged
ratio of domestic market capitalization to GDP, and the lagged change in the nominal exchange rate.
All these variables could potentially have some effects on M&A activity through making a given
developing country more attractive or less attractive to foreign investors. One at a time, each of these
variables is added to the base regression. The third to the eighth columns of Table 2 depict the results
of these regressions14.
Before delving into the specifics of each of these regressions, a couple of general observations
are in order. First, the inclusions of additional variables have little impact on the point estimates and
statistical significance of the variables from the base regression. Only when domestic stock market
indicators are included, the estimates of some of these coefficients deviate somewhat from the values
observed in the base regression which could be attributed to the drop in the sample size as explained
later. Second, other statistical criteria point toward the consistency of the estimation procedure. The
Sargan test indicates the validity of the used instruments in all regressions. The results show a
significant negative first order serial correlation and the absence of second order serial correlation
among residuals, indicating that the disturbances are not serially correlated. Finally, the Wald test
points to the joint significance of explanatory variables in each estimated regression.
The first variable is the lagged index of exchange rate variability. This variable could be
viewed as a proxy for macroeconomic risk since a high variability in the nominal exchange rate could
result in increasing the level of uncertainty in the economy15. Indeed, it was found to have a slight
negative effect on FDI flows (Kamaly, 2003). According to Table 2, the coefficient of the lagged
index of exchange rate variability took the expected negative sign but suffered from a low level of
significance. Similarly, the proxy for financial development, the M2 to GDP ratio, turned out to have a
positive but insignificant effect on M&A (fourth column in Table 2).
The expectation hypothesis postulates a positive relationship between M&A activity and a
bustling domestic stock market. Including the change in S&P500 index does not put this conjecture to
the test since this index is external to developing countries’ stock markets. To examine this link, two
proxies for the level of activity of the domestic stock market are included in the regression: the total
13
The S&P500 index includes mostly multinational companies. In addition, the S&P500 index is highly correlated with other stock market indices in the
rest of the industrialized world.
14
Two political variables, democracy index and durability of the political regime, were tested but they turned out to be totally insignificant.
15
Another proxy for macroeconomic risk, the index of interest rate variability, also turned out to have a negative but insignificant effect on M&A.
International Research Journal of Finance and Economics - Issue 8 (2007) 26

value of stocks traded as a percentage of GDP and market capitalization of listed companies as a
percentage of GDP16. The inclusion of these variables led to a decrease in the sample size of almost
20% due to the unavailability of stock market data for a number of countries in the sample.
The results of these regressions are summarized in the fifth and sixth column of Table 2.
Surprisingly, the coefficients of these two variables are negative and statistically significant, especially
the total value of stocks traded. This is an unexpected result since it implies that stock market booms
have a negative effect on M&A activity. It is true that a substantial amount of M&A transactions are
conducted outside the stock market (Melicher et al., 1983); however, this observation would imply that
these indicators should have an insignificant effect on M&A. One could think of two possible
justifications for this result. First, it is often the case that a slowdown in the level of activity of the
stock market is associated with a similar drop in the stock market return or stock prices. This
depreciation in the stock prices may create some valuable investment opportunities, especially when
prices reach “fire-price” levels. Another possible explanation appeals to the observed inverse
relationship between different types of capital inflows, especially during the second half of the 1990s
(Kamaly, 2003). Specifically, one could think of a situation where a foreign investor wishes to invest
in a certain sector in a given developing country. If the stock market is underdeveloped, then most
probably our investor may decide to acquire some shares in a company within this sector, which is in
most cases classified as an M&A transaction. The converse is also possible. If the stock market
improves in terms of depth and development, then our investor would be inclined to invest in the stock
market rather than directly acquire equity shares in some companies (Fernández-Arias and Hausmann
2000).
This significant negative effect of domestic stock market indicators and the insignificance of
real GDP growth suggest that aggregate M&A activity does not follow the expectation hypothesis. On
the other hand, the negative effect of the interest rates on M&A activity to developing countries should
not be regarded as an evidence for the cost of capital hypothesis, since the hypothesis links aggregate
M&A activity to the prevailing domestic interest rate not the international interest rate. The
significance of both the international interest rate and the change in the S&P500 index supports the
push story where changes in industrialized countries’ macroeconomic variables could bring about
changes in the flow of capital directed to developing countries. Similar to aggregate FDI, M&A flows
seem to be procyclical in nature as lower international interest rates and bulls market in the US
encourage M&A activity directed to developing countries.
A number of empirical studies have tried to verify the link between FDI and the exchange rate,
see for example Caves (1989), Froot and Stein (1991), Swenson (1994), and Blonigen (1997). Most of
these studies have confirmed the existence of such a relationship. To verify the existence of such a link
and to determine its direction, the lagged change in the nominal exchange rate was added to the base
regression. The results of this regression are depicted in the seventh column of Table 2. The
coefficient of the lagged change in the exchange rate is positive and highly significant. This result is in
line Froot and Stein (1991), and Gastanaga, Nugent and Pashamova (1998), who argue that a
depreciation of the host’s currency makes its firms look cheaper in the eyes of foreign investors. In
addition, this result is consistent with the course of M&A activity which soared during the time of the
Asian crisis in 1997 and 1998. This positive association between M&A and depreciation is likely to be
driven by the effect of financial and currency crises on the nontradable sector, as argued in the previous
section and supported by changes in the composition of M&A as depicted in Figure 2.
This association between M&A activity and depreciation could be used to elucidate one of the
puzzles surrounding FDI flows in the 1990s; namely, the stability of FDI, as opposed to other types of
capital flows, in the face of financial turmoil. Despite this buoyant track of M&A during and after the
Asian crisis, FDI flows were stagnant. In fact, the same variable, the lagged change in nominal
exchange rate was found, to have a negative effect on FDI flows in the 1990s (Kamaly, 2003).
Juxtaposing these results and observations, one could deduce that a depreciation in the host’s currency

16
The number of listed companies was also considered and yielded similar results but with a lower level of significance.
27 International Research Journal of Finance and Economics - Issue 8 (2007)

props up M&A, but reduces greenfield investment17. Since greenfield investment constitutes more
than 60% of FDI flows, the combined effect of a change in the nominal exchange rate is slightly
negative.

V. Conclusions
Using a comprehensive dataset on M&A to estimate a dynamic panel data model, this study sheds
some light on the direction and determinants of aggregate M&A activity directed to developing
countries in the 1990s. Results indicate that aggregate M&A activity embodies a moderate level of
inertia, though much less than the one bolstering total FDI to developing countries. Interest rates do
affect M&A in the anticipated negative direction. Openness has a significant effect on M&A but,
quantitatively, its effect is minimal. Increases in S&P 500 index seem to abet the demand for
developing countries’ firms.
The trend of aggregate M&A activity throughout the 1990s and the positive effect of
depreciation on M&A explain the exuberant M&A transactions- “fire-sale FDI”- that coincided with
the Asian crisis. The mélange of depressed domestic demand, financial crunch, and sinking local
currency caused a dramatic fall in the value of local firms-especially in terms of dollars-, which led
foreign investors to stampede to acquire these bargain deals. This positive association between
aggregate M&A activity and the nominal exchange rate, together with the reported weak negative
relationship between the depreciation and FDI flows, lead us to suspect a strong negative connection
between greenfield investment and the change in nominal exchange rate; however, further research is
needed to verify this conjecture.
The level of activity in the domestic stock market appears to deter M&A to developing
countries. This is a somewhat unexpected result since empirical evidence using US data has often
confirmed the existence of a positive link between stock returns and M&A. Two explanations were
offered to reconcile this result: First, if the level of activity of the stock market moves in tandem with
its return, then it could be the case that foreign investors decide to acquire developing countries’
companies when domestic stock markets plunge. Another explanation is related to the investor’s
choice of the type of investment, where investors faced with an underdeveloped stock market are more
likely to opt for acquiring equity directly through M&A; and vice versa.

Acknowledgement
I’m grateful to Carmen Reinhart, Michael Binder, Fernando Broner, Harry Kelejian, and Guillermo
Calvo for refining my ideas, and useful suggestions through the different stages of my research. I also
benefited from discussions and comments from Sergio Schmukler, Daniel Ortega, Federico Guerrero,
John Shea, John Haltiwanger, and other participants of the international breakfast seminar and
Macro/International seminar in the University of Maryland at College Park.

17
Aguiar and Gopinath (2005) have verified that M&A activity increases during crisis; however, the mechanism is totally different. They argue that
domestic firms face a liquidity constraint that intensifies during financial crisis which adversely affects firm’s investment opportunity and hence its
value. Foreign firm on the other hand, does not face this liquidity constraint; moreover, it has access over a superior technology. Consequently, foreign
firm can extract rent by acquiring domestic firm especially during crisis time when the value of the domestic firm drops even further.
International Research Journal of Finance and Economics - Issue 8 (2007) 28

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International Research Journal of Finance and Economics - Issue 8 (2007) 30

Data Appendix
M&A data is obtained from SDC Platinum Worldwide Mergers and Acquisitions Databases.
However, the main source of economic data is the World Economic Outlook (WEO) database (IMF).
The data for the exchange rate and interest rate is obtained from the International Financial Statistics
(IFS) database (IMF). Domestic stock market indicators are obtained from World Bank Development
Indicators database. As for the political data, it is obtained from the Center for International
Development and Conflict Management (CIDCM) at the University of Maryland at College Park.
Below is a description and the derivation of variables used in this study.
1. Weighted average of Bond yield in the G7 countries: This variable is calculated as a weighted
average of bond yield in the Group of Seven countries (G7) taking their GDP as weights.
2. Openness: This variable is defined as the ratio of the sum of export and import to GDP.
3. Index of exchange rate variability: This variable is calculated from the series of nominal monthly
exchange rates. For each country, the rate of change of monthly exchange rate was used to
compute its variance. For each year, these figures for variance are used to construct an index of
exchange rate variability. This index varies from 1 to 4 (1 indicating the least variability and 4
indicating the highest variability).
4. Change in nominal exchange rate: This variable is calculated by taking the average of the change
in the nominal monthly exchange rate.
5. Index of interest rate variability: This variable is calculated from the series of nominal monthly
(deposit) interest rates. For each country, the rate of change of monthly interest rate was used to
compute its variance. For each year, these figures for variance are used to construct an index of
interest rate variability. This index varies from 1 to 4 (1 indicating the least variability and 4
indicating the highest variability).
6. Inflation rate: This variable is calculated as the rate of change of Consumer Price Index (CPI).
7. Democracy index: This index varies from –10 (strongly autocratic political system) to 10
(strongly democratic political system).
8. Durability of the political regime: This represents the number of years since the most recent
regime change.