SURVEY - MASTERING INVESTMENT: Room for improvement in protecting investors Strong institutions and profits, as well as growth, are vital for success, but foreign investors can have difficulty assessing the risks, says David Beim
Financial Times; Jul 2, 2001
By DAVID BEIM

Investors in emerging financial markets were filled with enthusiasm in the early 1990s. Later in the decade, despair predominated. What does the future hold? Many people imagine that investors have fled emerging markets and capital flows have reversed, but Figure 1 shows this is not true. The flow has slowed and for 1998-99 was negative in Asia, but investors have continued to make net investments. Foreign direct investors (that is, companies buying plants and businesses) show an even stronger pattern of continuing investment.

Developing countries typically have excellent growth opportunities but weak institutions: imperfect rule of law, poor financial regulation, banks saddled with non-performing loans and so on. Investors enter these markets with expectations of high returns but often with little understanding of the problems. As a result, prices are bid up to unrealistic levels in good times and often followed by financial crisis and institutional collapse.

A great deal has been learned in the 1990s, and investors have become more selective. It is no longer appropriate, if it ever was, to buy a cross-section of the whole emerging market asset class. Rather, one must select particular countries. In particular, for investments in shares and bonds to be rewarding, three things must hold:

selected countries and companies must be growing at strong, sustainable rates;

growth must be profitable;

profits must be shared with outside investors.

In a perfect world, these issues would be reflected in the prices of securities. Investors, however, have great difficulty in understanding and assessing the sources of sustainable growth and the risk from weak institutions. Only when that risk has become obvious, as now, are emerging market securities priced at levels that can provide high future returns.

Sustainable growth

Investment in emerging financial markets is based on a simple idea: that developing countries have better growth opportunities than industrialised countries. For this theory to work, there must be real, sustainable growth in the economy. Unless citizens are getting richer, it is unlikely that outside investors will get richer either, at least over the long term. Indeed, if investors got rich while citizens got poorer, it is likely that institutional rules would be changed.

Table 1 shows that real gross domestic product per head is growing more rapidly in most emerging markets than in the industrial world, even in the crisis-laden period 1995-99. Of course, many experienced negative growth in the 1990s, particularly in Africa and eastern Europe. But some developing countries have grown very rapidly over an extended period of time. A good example is Korea.

Just 30 years ago Korea had the same standard of living as many countries in Africa. In 1970 Korea had a GDP per head of Dollars 267, a figure similar to Ghana (Dollars 257) and Ivory Coast (Dollars 271). However, by 1980 it was Dollars 1,512, comparable with Poland's Dollars 1,533 and Syria's Dollars 1,501. By 1990 it had reached Dollars 4,422, pressing close to Portugal (Dollars 5,318) and Greece (Dollars 5,794). Meanwhile, in 1990 Ghana stood at Dollars 216 and Syria at Dollars 1,462.

How did Korea do it? Fundamentally, the country set out to join the global economy, committing itself to improve technical knowledge and grow exports through products of increasing complexity. By competing, Koreans forced themselves to perform at ever-higher levels and achieved a far higher standard of living.

A contrasting case is Argentina. In the 1930s it had a European standard of living, but since then it has tended to coast. In the 1990s Argentina made great strides in reforming its monetary and financial system, but it still relies on commodities such as wheat, beef and hides, and has not modernised the sources of its wealth.

Embracing the world economy tends to accelerate growth because of convergence: when people, ideas, goods, services and money can flow easily across borders, and companies from all countries compete in a global marketplace, countries become more like each other. This means that countries with lower GDP per capita are likely to catch up with others by growing more rapidly.

Convergence works very well when borders are fully open. For example, the US in the late 1880s showed large internal differences in wealth: southern states were the poorest and western states the richest. But with wide-open internal borders, the southern states grew more rapidly than the average and western states more slowly, so they converged.

Those who demonstrate loudly about the supposed evils of globalisation would do well to ponder this fact. In the modern era no country has grown richer except by embracing the outside world. Those that have tried to isolate themselves from global ideas and influences have stagnated or become poorer.

Investors, then, should begin with a country's openness to global markets and global ideas. This quickly shows up in its real growth rate. Of the eight top-growth countries for 1995-99, four represent the export-driven "East Asian model". A fifth (India) has been more tentative about openness and reform, but starts from such a low base that even moderate reforms plus great strength in technical education have made it one of the fastest-growing markets in the set.

Greece is enjoying the fruits of convergence within the European Union. Poland represents the most thoughtful and successful transition from communism to capitalism; its superior growth in the late 1990s reflects its commitment to strong legal and financial infrastructure as well as convergence with the neighbouring EU. Brazil is a unique country that has aggressively embraced technology. Also, it has the most sophisticated financial markets in Latin America and promotes exports.

Is growth profitable?

The next requirement is that the growth be profitable. GDP is a top-line concept: a company's contribution to its country's GDP is, roughly, its sales (less its purchases of intermediate goods from other companies). To say that a country's GDP is growing is to say that most companies' revenues are growing. However, investors know (or should have learned from the dotcom mania) that a growing top line does not necessarily guarantee a growing bottom line.

A growing bottom line requires efficiency and productivity - getting the most output possible per unit of input. Economist Paul Krugman once observed that productivity is not everything, but in the long term it is almost everything. This is because inputs are invariably limited. Only by constantly upgrading ideas, technology and processes can companies and their owners get richer, and economies keep growing. What gets in the way of this process?

Sadly, the answer is often government. In developing countries, government is much more intrusive in the economy than is the case in Europe or the US and this typically damages profitability and efficiency.

The first issue is corruption, in which government officials seek private enrichment from the private sector for permits, contracts and so on. Bribery acts like a substantial tax, reducing the profitability of companies and altering their incentives in highly unproductive ways. Corruption is a problem almost everywhere, but seems to be especially acute in much of the developing world.

Corruption is now being measured, mainly by survey data, and studied by economists to document its effects. Table 1 shows how these measures compare in a number of developing countries, in this case documented by Transparency International, a German non-profit organisation.

A related issue is the bureaucracy that governments impose. India, for example, was burdened for decades by the "licence raj", which meant companies could not make even minor changes in assets or business without a licence. The resulting cost, delay and inefficiency held back growth.

The Peruvian writer Hernando de Soto raised the difficulty of legally starting a business, even a simple one, in developing countries such as Peru. The process can drag on for years, serves no evident social purpose and is highly correlated with corruption.

Table 1 shows the result from a study into the number of procedures required to start a new business.

More broadly, governments often like to allocate capital directly rather than allowing this to be done by markets. Government is about power and the ability to allocate capital resources is a major component of such power. It may do this directly by owning banks, or indirectly by giving "guidance" to banks and companies.

A good example is the Korean government's push, in the late 1970s, toward heavy and chemical industries, which resulted in over-investment, excess capacity and losses. Government officials probably believed they knew better than companies what would be good for the economy. Unfortunately, government choices are more often driven more by politics - favouring certain individuals, regions or companies - than by concern for economic performance. The consequence is usually growth of the top line but losses on the bottom line.

The table also shows the fraction of bank assets directly controlled by the private sector, as a proxy for the extent of private allocation of capital. Where this measure is 100 per cent or nearly so, financial markets are most fully trusted to make capital allocation decisions, which should result in the greatest efficiency.

Investors need to look not just at top-line growth but also at bottom-line productivity and efficiency. They will do well to avoid countries where the government is too intrusive. Table 1 gives an indication of where such problems are particularly severe.

Are profits shared?

Table 1 shows that the Chinese economy has grown very quickly, thanks largely to an export-driven growth policy and a burgeoning private sector. Capital has been provided by wealthy Chinese businessmen in Hong Kong and throughout southeast Asia. However none of this guarantees that outside investors will do well in China.

In the industrial world it is taken for granted that profits are shared by outside providers of capital, but in many countries this cannot be assumed. Things can go wrong on two levels: managers may steal from owners and inside investors may steal from outside investors.

Managerial theft was most obvious in the transition of formerly communist countries in central and eastern Europe. Enterprises were controlled by state-appointed managers who saw the transition from communism as a golden opportunity to appropriate wealth. They did this most readily by selling assets of established enterprises, which they controlled, to smaller ones that they actually owned, at prices far from fair market value. This practice, called "tunnelling", was blatant in Russia and widespread in many other transition countries.

In most developing countries, however, companies are controlled by individuals and families playing active managerial roles, so that abuse of owners by hired managers is less common. The greater temptation is for inside owners/managers to abuse outside owners and lenders. This is often done through complex conglomerate structures, making it hard for outside investors to understand exactly who has how much interest in which assets. These structures are deliberately opaque and are often used to divert profits from outside investors.

It is said that sunlight is the best disinfectant and investors should put their funds only in countries and companies where financial disclosure meets certain standards. Since most businesses do not want to reveal their affairs, government must require some level of disclosure. There must also be a decent respect for the rule of law, so insiders feel an obligation to share profits appropriately with outside suppliers of capital.

Table 1 has a column on financial disclosure and another column that ranks countries' respect for the rule of law. When a country such as China grows rapidly but has very weak financial disclosure and very weak rule of law, someone will get rich but it is unlikely to be foreign investors.

If a government wants to strengthen capital markets, it will pass laws giving rights to outside owners and lenders. Research has focused on the quality of shareholder and creditor rights. It shows these rights are generally strongest in countries whose legal systems derive from the Anglo-Saxon tradition and weakest in those following the French tradition.

Shareholder rights include measures such as the right to have one vote for each share, the right to cast such votes with a mailed-in proxy, freedom from the need to deposit shares before voting and so forth. These rights are used for Table 1.

Creditor rights mainly concern bankruptcy procedures. Can lenders force a company into bankruptcy or are there severe restrictions? In bankruptcy, are secured interests protected by the value of their collateral? Does secured debt get paid first? Do managers remain in control during bankruptcy or does a court take over?

Moreover, investors need more than laws. They also need a regulatory agency to enforce the laws. Foreign investors are uniquely vulnerable. Their interests are likely to be ignored unless a local securities commission looks after them.

One indicator for external investors is the size of internal financial markets relative to GDP. It is no accident that stock markets are large relative to GDP in countries such as Taiwan and the Philippines, which score 6-8 on shareholder rights. Where internal investors seem well treated, external investors should be safer.

The future

There will not be any euphoria over emerging markets for some time, but we can expect progress in some countries. Developing countries need external capital, so as investors become more demanding countries will have incentives to reform.

Many developing countries will undoubtedly grow faster than the economies of Europe and the US, particularly if their growth strategies are export-driven and their private sector is vigorous and competitive. But investors need to see more than rapid growth. In addition they need a good infrastructure of law, information, regulation and governance. This is hard to build, but the need for capital will be an enduring incentive and we have reason to hope for some solid success stories.

Further reading

de Soto, H. (1989) The Other Path: The Invisible Revolution in the Third World, New York: Harper & Row.

de Soto, H. (2000) The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else, New York: Basic Books.

de Thorsten Beck, T., Demirgx�-Kunt, A. and Levine, R. (1999) A New Database on Financial Development and

Structure, World Bank (http://econ.worldbank.

org).

de Johnson, S. and Shleifer, A. (1999) "Coase v. the Coasians", National Bureau of Economic Research, working paper 7447 (http:// papers.nber.org).

La Porta, R. et al (1998) "Law and finance", Journal of Political Economy, 106, 2, 1113-1155.

La Porta, R., Lopez-de-Silanes, F. and Shleifer, A. (2000) "Government ownership of banks", National Bureau of Economic Research, working paper 7620 (http:// papers.nber.org).

Djankov, S. et al (2000) "The regulation of entry", National Bureau of Economic Research, working paper 7892 (http://papers.nber.org).

David O. Beim is a professor of finance and economics at Columbia Business School.

Copyright: The Financial Times Limited 1995-2002