MARKETS AND INSTITUTIONS MARKETS AND INSTITUTIONS IN MIDDLE INCOME COUNTRIES: IN MIDDLE INCOME COUNTRIES: FOREIGN INVESTORS IN EMERGING DEMOCRACIES FOREIGN INVESTORS IN EMERGING DEMOCRACIES Javier Santiso Chief Economist & Deputy Director OECD Development Centre Casa de América Madrid, 8-9 June 2006
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MARKETS AND INSTITUTIONS IN MIDDLE INCOME COUNTRIES: FOREIGN INVESTORS IN EMERGING DEMOCRACIES Javier Santiso Chief Economist & Deputy Director OECD Development.
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MARKETS AND INSTITUTIONS MARKETS AND INSTITUTIONS IN MIDDLE INCOME COUNTRIES:IN MIDDLE INCOME COUNTRIES:
FOREIGN INVESTORS IN EMERGING DEMOCRACIESFOREIGN INVESTORS IN EMERGING DEMOCRACIES
Javier Santiso
Chief Economist & Deputy DirectorOECD Development Centre
Casa de AméricaMadrid, 8-9 June 2006
Foreign Investors and Emerging Democracies
• Introduction: A Research Agenda
• 1. Are Foreign Direct Investors Politically Correct?
• 2. Financial Markets and Emerging Democracies.
• 3. A Case Study: Wall Street and Brazilian Elections.
Introduction: A Research Agenda
• A Research Agenda: “Foreign Investors and Emerging Democracies: The Political Economy of Capital Flows in Developing Countries” (book project, 2005-2007).
• Capital Flows and Political Regimes: From Montaigne’s “Doux Commerce” to Hirschman’s “Passions and Interests”.
• Financial Markets and Politics: Wall Street and Elections in Emerging Democracies - based on, Juan Martinez and Javier Santiso, «Financial Markets and Politics: The Confidence Game in Latin American Emerging Democracies», International Political Science Review, Vol. 24, n°3, July 2003, pp. 363-395;
• Financial Markets and Politics: Javier Santiso, “The Political Economy of Emerging Markets: Actors, Institutions and Financial Crises in Latin America”, New York and London, Palgrave, 2003.
Two Global Trends: A Democratic Wave …
The Twentieth Century Democratic Wave in Latin America: Number of Elections from 1945 to 2000
0
10
20
30
40
50
60
70
80
90
100
1940's 1950's 1960's 1970's 1980's 1990's
Presidential Parliamentary Total
… That has also been a Latin American Wave
The Twentieth Century Democratic Wave:Total number of presidential elections from 1945 to 2000
0
50
100
150
200
250
World Totals South/Latin America
World Totals 19 43 42 41 67 222
South/Latin America 15 29 29 27 38 41
1940's 1950's 1960's 1970's 1980's 1990's
A Second Global Trend During the 90´s: A boom of capital flows to
emerging markets
Net private capital flows to emerging markets (billions of US $)
Comparative attractiveness of various markets for selected attributes
(weighted score of country rankings)
Comparative attractiveness of various markets for selected attributes
(weighted score of country rankings)
Comparative rates of stability among large emerging markets
Source: A.T. Kearney
Percentage of global investors that ranked countries for High, Medium, and Low Risk Percentage of global investors that ranked countries for High, Medium, and Low Risk
High24%
Medium63%
Low13%
China China
High54%
Medium41%
Low5%
Brazil Brazil
High30%
Medium58%
Low12%
India India
High17%
Medium62%
Low21%
Mexico Mexico High9%
Medium47%
Low44%
Poland Poland
Relative risk profiles among large emerging markets
But, what about Democracy ?
Democracy Index * 2002
0
0
6
6
7
8
8
8
9
10
10
10
10
10
0 2 4 6 8 10
Cuba
China
Ecuador
Venezuela
Colombia
Argentina
Brazil
Mexico
Peru
Costa Rica
Bolivia
Chile
Uruguay
US
more democraticless democratic
Source: Based on Jaggers, Keith y Monty G. Marshall. (2003). "Polity IV: Political Regime Characteristics and Transitions, 1800-2002". University of Maryland, 2003.
…and, Economic Freedom ?
Index of Economic Freedom
1,80
2,35
2,50
2,65
2,65
2,80
2,80
2,95
3,00
3,00
3,45
3,50
3,55
4,45
0,00 1,00 2,00 3,00 4,00 5,00
US
Spain
Uruguay
Bolivia
Costa Rica
México
Peru
Argentina
Brazil
Colombia
Ecuador
Venezuela
China
Cuba
less libertymore liberty
Source: Index of Economic Freedom 2003
And Property Rights ?
Index of Property Rights Protection
1
2
3
3
3
3
3
3
4
5
5
0 1 2 3 4 5
Cuba
China
Brazil
Colombia
México
Panama
Peru
Venezuela
Argentina
Chile
US
More protectionLess protection
Source: La Porta, Rafael, Florencio Lopez-de-Silanes, Christian Pop-Eleches, Andrei Shleifer. (2003). Judicial Checks and Balances. NBER working paper 9775. Based on "Economic Freedom Index 1997".
2. Wall Street and Emerging Democracies
Politics in Developing Countries Matter to Wall Street Investors
Calpers - Wilshire Macro-Factors Weights
Category Assigned Weight Data Sources
1 Political Stability * 12,50% Freedom House, Global Competitiveness Report, ICRG
Politics in Developing Countries Matter to Wall Street Analysts
JP Morgan Political Timetable for 2004: Electoral Calendar and Market Implications
Month Country Elections Risk
March 14 Russia President HighMarch 20 Taiwan President HighMarch 21 El Salvador President LowMarch 28 Turkey Municipal NeutralApril 5 Indonesia Parliament HighApril Algeria President HighApril South Korea Parliament NeutralMay 2 Panama General NeutralMay 10 Philippines General HighMay 16 Dom. Republic President HighMay Slovakia President NeutralJuly Indonesia President NeutralApril-June South Africa Parliament LowApril-June Lebanon Parliament HighSeptmeber Hong-Kong Parliament LowOctober Ukraine President HighOct-Nov Uruguay General HighOctober Tunisia General NeutralOctober Slovenia Parliament NeutralNov04-Dec05 Romania General LowQ2 due by October India Parliament LowQ2 due by November Malaysia Parliament LowDecember 28 Serbia Parliament MediumMid-year Qatar Parliament Low
Source: JP Morgan, Emerging Markets Outlook for 2004, December 2003.
But Are Financial Markets Politically Correct ?
• Interactions between politics and economics are also central to understanding financial crisis in emerging markets.
• Frieden, Ghezzi and Stein argued that weak governments might be more vulnerable to currency crises during election years. In a detailed study of the behaviour of real and nominal exchange rates in Latin America they confirmed that changes in exchange rate regimes coincided with elections.
• The three most recent and significant financial crises in the region -- Mexico in 1994, Brazil in 1999 and Argentina in 2001 -- took place during the corresponding presidential or parliamentary electoral year.
Financial Markets and Emerging Democracies
Financial Crises and Emerging Democracies, 1989-2004
Country Peak Crisis Year Nearest Election Dates
Argentina 1989 May 1989India 1991 May/June 1991Mexico January 1995 August 1994Bulgaria 1996 April 1997Thailand 1997 November 1996South Korea 1997 November 1997Venezuela 1998 December 1998Russia 1998 December 1999Brazil January 1999 October 1998South Africa 2001 June 1999Turkey 2001 November 2002Argentina 2001 October 1999-April 2003Brazil 2002 October 2002
Source: Based on Whitehead, 2003.
Historically, institutional instability and political uncertainty have
favoured crisis
1825
1830
1835
1840
1845
1850
1855
1860
1865
1870
1875
1880
1885
1890
1895
1900
1905
1910
1915
1920
1925
1930
1935
Argentina (28%)
Bolivia (18%)
Brazil (17%)
Chile (24%)
Colombia (49%)
Costa Rica (30%)
Ecuador (62%)
Guatemala (48%)
Honduras (79%)
Mexico (57%)
Nicaragua (45%)
Paraguay (26%)
Peru (39%)
Salvador (29%)
Santo Domingo (41%)
Uruguay (12%)
Venezuela (45%)
The Timing Game: Political Cycles and Crises in Latin
America
Nominal exchange rate depreciationand government change
Mexico and the steady hand of the six-years period
Monthly exchange rate variation(%)
-20
0
20
40
60
80
100
ene-
76
ene-
78
ene-
80
ene-
82
ene-
84
ene-
86
ene-
88
ene-
90
ene-
92
ene-
94
ene-
96
ene-
98
ene-
00
ene-
02
electoral year
electoral year
electoral year
electoral year
electoral year
Source: Elaboración propia en base a FMI
The Mexican peso behaviour before and after the elections
(daily ppd; 90 days before and after)
9,0
9,2
9,4
9,6
9,8
10,0
10,2
7,7
7,8
7,9
8,0
8,1
8,2
8,3
8,4
8,5 Elections
1997
2000
A First Approach to Wall Street Political Preferences: The Index
Game
EMBIL EMBI+ EMBI EMBI GLOBAL EUR Diversified GLOBAL Diversified•Countries 19 31 31 19•Includes defaulted? Yes Yes Yes Yes•Includes Quasi Sovereigns?No Yes Yes Yes•ICriteria for inclusion BBB+ or Low/Middle Low / Middle Low/Middle
under income income income•Min. Issue Size $500m $500m $500m €500m•Liquidity Criteria Yes No No No•Face Constraints No No Yes No•Market Cap $158bn $214bn $138bn €26bn•Largest Country Mexico Mexico Mexico Turkey•Largest Weight 22.4% 20.7% 12.2% 10.3%•Sharpe Ratio* 0.57 0.59 0.68 1.33**•Historic data back to Dec ‘93 Dec’93 Dec’93 Dec’98
More Diversification
Less Liquidity
Source: JPMorgan, Mar 31, 2002. * Sharpe ratios for Dec ‘90-Nov ‘02. Pre 1993, we link EMBI returns. ** € EMBIGD Sharpe is Dec ‘98 - Nov ‘02.Investors are moving to EMBIGD for diversification
The Index Game: Market Capitalisation
B
14%
BB
33%
BBB
31%
A
10%
NR to
CCC
12%
Source: JPMorgan, Mar 31, 2003.
By Region By Rating (Av. = BB)By Country
Tur
6%
ME /
Africa
10%
Bra
9%
Other
Eur
8%
Kor
6%
Phil
6%
Mal
7%
Rus
11%
Other
Asia
2%
Mex
12%
Ven
4%
Col
5%
Other
Latin
14%
EMBIG $ (ext): $210bn EMBIG EUR (ext): EUR 36bn EM Corporates: $100bn Local Markets (Free): $900bn EM Total: $1,400bn Source JP Morgan, Mar 31, 2003
EMBI Global Diversified Weights
Latin
45%
Europe
24%
Asia
21%
ME /
Africa
10%
GBI:$7,000bn
US Aggregate:$7,000bn
Global Aggregate:$14,000bn
US HY: $700bn Source JP Morgan, Mar 31, 2003
The Political Economy of Indexes
JP Morgan Indexes Coverage in 2000
Index EMBI EMBI+ EMBI (Global) EMBI Global Constrained) Polyarchy Scale Polity Level
No. Countries 11 16 27 27
Latin America weights (in %) 84% 70% 61,50% 52%
Countries Covered Countries Covered
Argentina x x x x 0 8 ArgentinaChile x x x 0 9 Chile
Colombia x x x 3 7 ColombiaBrazil x x x x 0 8 Brazil
Ecuador x x x x 2 EcuadorMexico x x x x 0 8 Mexico
Panama x x x x 0 PanamaPeru x x x x 0 Peru
Venezuela x x x x 2 Venezuela
China x x 10 ChinaMalaysia x x 2 Malaysia
Philippines x x x 2 8 PhilippinesSouth Korea x x x 1 8 South Korea
Thailand x x 2 9 Thailand
Bulgaria x x x x 0 8 BulgariaCroatia x x 1 7 Croatia
Hungary x x 0 10 HungaryPoland x x x x 0 9 PolandRussia x x x x 1 7 Russia
Algeria x x 3 AlgeriaGreece x x 0 10 Greece
Ivory Coast x x 5 Ivory CoastLebanon x x 1 LebanonMorocco x x x 3 MoroccoNigeria x x x x 10 Nigeria
South Africa x x 1 9 South AfricaTurkey x x x 3 7 Turkey
3. A Case Study: Wall Street and Brazilian Elections
Analysts Analyzed: Wall Street and the 2002 Brazilian Presidential
Election.
0
500
1000
1500
2000
2500Brazilian & emerging bond spreads
Brazil EMBI+ spread
EMBI+ spread
Source: J P Morgan
Wall Street Shifting Involvements: The Lula Effect
Wall Street Strategists's Recommendations on Brazil Bond Debt 2002
Rating Change Date
ABNAmro Neutral from Overweight May 1st
Goldman Sachs Neutral from Overweight May 1st
Santander Investments Neutral from Overweight May 3rd
Deutsche Bank Neutral from Overweight May 9th
JP Morgan Chase 1st reduction of overweight June 4th2d reduction of overwight July 1st
Overweight to marketweight July 22thMoved to Underweight December 9th
BCP Securities Sell August 8th
Morgan Stanley Downgrade to underperform August 12th
Salomon Smith Barney Changes in marcoeconomic forecast August 20th
UBS Warburg Increased Overweight August 30th
Bear Stearns Cuts to Underweight September 19th
Merrill Lynch Moved to Underweight September 25th
Goldman Sachs Moved to Underweight September 27th
Merrill Lynch Moved back to Marketweight October 4th 2002
Source: Based on JBIC and Wall Street investment banks reports, 2002.
Extreme Overreactions: Exit, Voice and Loyalty in Financial Markets
Countries that Traded North of 2 000 bps
EMBIG Countries which traded above 2 0002 bps spreads and defaulted
Days Above 2000 bps Default Datebefore default
Argentina 38 December 2001Russia 40 October 1998
Ivory Coast 2 March 2000Ecuador 163 September 1999
EMBIG Countries which traded above 2 0002 bps spreads and avoided default Days Above 2000 bps Period
Mexico 8 March 1995Venezuela 94 Spring 95, Aug 98Bulgaria 32 Summer 94, Spring 95Algeria 10 April 1999Nigeria 308 94-95, 2000
Pakistan 5 September 2000Ukraine 97 June 2002, Spring 01Brazil 35 June 2002-October 2002
Source: Own estimations for Brazil; and JP Morgan Chase, Emerging Markets Outlook, August 2, 2002.
Brazilian Elections and Financial Markets: A Case Study in Historical
Perspective.
-1,5
-1,0
-0,5
0,0
0,5
1,0
1,5
2,0
2,5
3,0
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Electoralyear
Electoralyear
Real/Dollar Volatility
Daily change in %, monthly moving average
Plan Real End Plan Real
Electoralyear
Source: Bloomberg
-150
-100
-50
0
50
100
150SELIC volatility
Electoralyear
% m/m
Electoral year
Electoral year
Source: Bloomberg
In 2002 the opinion polls registered an evolution parallel to those experienced in 1994 and 1998 with a progressive decline of Lula’s
popularity from May-June.
20%
25%
30%
35%
40%
45%
02/0
1/02
18/0
1/02
05/0
2/02
21/0
2/02
11/0
3/02
27/0
3/02
15/0
4/02
02/0
5/02
20/0
5/02
10/0
6/02
27/0
6/02
15/0
7/02
01/0
8/02
19/0
8/02
05/0
9/02
0
200
400
600
800
1000
1200
1400
Voter intention for Lula in the opinion polls
(left)
bp.Spread Brazil-Emerging Countries and Electoral Polls2002
Source: Datafolha, JP Morgan
On comparing the graphs corresponding to each of the three last electoral years, a certain “seasonality” can be observed with regard to the movement of the spread between Brazil
and the group of emerging bonds.
20%
25%
30%
35%
40%
45%
03/0
1/94
28/0
1/94
24/0
2/94
22/0
3/94
18/0
4/94
13/0
5/94
09/0
6/94
06/0
7/94
01/0
8/94
25/0
8/94
21/0
9/94
18/1
0/94
14/1
1/94
09/1
2/94
-180
-80
20
120
220
320
420
520
bp
Voter intention for Lula in the opinion polls
(left)
Spread Brazil-Emerging Countries and Electoral Polls1994
20%
22%
24%
26%
28%
30%
32%
-100
-50
0
50
100
150
200
pb.
Voter intention for Lula in the opinion polls
(left)
Spread Brazil-Emerging Countries and Electoral Polls1998
However, the further deterioration of the Brazilian debt position in the May-July period is associated with other factors, such as the inherent dynamism
of the Brazilian debt.
0
20
40
60
80
100
1994
1995
1996
1997
1998
1999
2000
2001
2002
Domestic Public Debt Composition
Fixed rate
Interest rate indexed
Exchange rate indexed
Others
Source: Banco Central do Brazil
This “valley of transition” aspired to limit the impact of the elections on
Brazilian debt.
0
5 000
10 000
15 000
20 000
25 000
30 000
35 000 Amortization Profile of Domestic Public Debt (jan-02)million reais
Source: Banco Central do Brasil
Lula and Ciro Effect versus Cardoso Exit
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
70%
02/0
1/02
18/0
1/02
05/0
2/02
21/0
2/02
11/0
3/02
27/0
3/02
15/0
4/02
02/0
5/02
20/0
5/02
10/0
6/02
27/0
6/02
15/0
7/02
01/0
8/02
19/0
8/02
05/0
9/02
0
200
400
600
800
1000
1200
1400
Voter intention for Lula and Ciro
in the opinion polls(left)
bp.Spread Brazil-Emerging Countries and Electoral Polls (lula + Ciro), 2002
Social Security Neutral Presentation 16-17 April 2.5 2.5 5.0
Tax Reform Neutral Presentation 16-17 April 2.5 2.5 5.0
Central Bank Autnonomy Positive Final vote expected by mid April 4.0 1.5 5.5
Bankrupcy Law Neutral Already in Congress 3.0 3.0 6.0
Reform Agenda 2.7 2.5 5.2Compositve Score (2)
Source: Merrill Lynch, April 2003.
Notes:(1): The scorecard summarizes the Progress Score, which range a higher score in a scale from 0 to 5 to a reform the closer is to being approved, and the Quality Score, also evaluated on a scale from 0 to 5 and with higher points the closer the reform's current form is to a first best reform.(2) Reform Agenda Composite Score gives the weighted score of the reforms as per the following weights: social security 50%, tax 25%, bankrupcy 15%, and Central Bank Autonomy 10%.
Lula Light: Institutional Reforms and Confidence Building
Brazil Reform Scorecard in December 2003 According to Merrill Lynch
Social Security Positive Approved by the Senate 2nd round 3,5 5 8,5
Tax Reform Positive Approved by the Sentate 1st round 2 4,8 6,8
Central Bank Autnonomy Neutral Complementary Law expected in 2004 4.0 2 6
Bankrupcy Law Neutral Approved by Lower House (next Senate) 3.0 4 7
Reform Agenda 3,1 4,5 7,6Compositve Score (2)
Source: Merrill Lynch, December 2003.
Notes:(1): The scorecard summarizes the Progress Score, which range a higher score in a scale from 0 to 5 to a reform the closer is to being approved, and the Quality Score, also evaluated on a scale from 0 to 5 and with higher points the closer the reform's current form is to a first best reform.(2) Reform Agenda Composite Score gives the weighted score of the reforms as per the following weights: social security 50%, tax 25%, bankrupcy 15%, and Central Bank Autonomy 10%.
Lula’s Government Temporal Adjustment
2003 Timetable for Congressional Passage of Brazilian structural reforms
Legislative Phase Pension Tax
Lower House Judicial Committee June 5 May 28Ad-hoc committee July 23 August 26
1st Floor Vote August 5 Septmeber 32d Floor Vote August 27 September 24
Senate Judicial Committee October 5 November 51st Floor Vote November 26 December 112d Floor Vote December 16 December 19
Source: JP Morgan, December 2003.
Voting of Reforms in Brazilian Congress(1st Cardodo Mandate)
Passage
Constitutional Amendment First Vote Last Vote Number of Months
Administrative reform 26-sept-95 11-mars-98 30
Social secutiry reform 24-Apr-95 15-Dec-98 44
Re-election amendment 26-Apr-95 04-juin-97 26
Extension of Fiscal Stabilization Fund 30-Aug-95 29-Feb-96 7
Reintroduction of CPMF Tax 30-Aug-95 24-juil-96 11
Sources: Based on CSFB and Brazilian Congress, 2003.
Debt Intolerance and Serial Defaulters
Debt Intolerance and Serial Defaulters: External Debt Defaults, 1824-2001, and Country Risk *.
Number of Defaults Percent of years in default Number of Years Institutional Investoror restructrings, 1824-1999 or restructrings, 1824-1999 Since last default Ratings,sept 2002
Source: Reinhart, Rogoff and Savastano, August 2003.
Conclusion: Enter The Matrix of The Political Economy Capital
Flows• The question of instability and uncertainty is central to
understanding the intricate links between financial markets and politics in emerging economies.
• Where institutions are weak, and consequently the government’s ability to honor its promises over time is questioned, the identity of the winning candidate becomes much more important to investors than in countries with strong and stable institutions.
• At a more fundamental level, examination of market reactions to 2002 presidential elections in Brazil encourages broader and systematic reflection on the relationship between democracy and financial markets.
• In the end, if we accept Przeworski's definition of democracy (i.e. a regime whose essence is the institutionalization of uncertainty locked in electoral outcomes), it opens the question of the political preferences of financial markets
In Search of a Better World: What About a Democratic
Premium?• In other terms, do financial markets give a positive premium to
democracies or, on the contrary, democratic elections in emerging countries, because they bring uncertainty, are systematically correlated with financial volatility, rising risk premiums and exchange rate ups and downs?
• Regarding creditworthiness, a recent research underlined that there is a lack of “democratic advantage”. Even if democracies are supposed to pay lower interest rates than authoritarian regimes (because more capable of making credible commitments to repay their debts), the evidence shows that this expectation is unfounded.
• What about Basel II? Would it be possible to think about a democratic premium, to link capital flows with political development?
In Search of a Better World:Ethical Governance and
Development• Banks are increasingly paying more attention to ethical issues.
In June 2003, nine banking operators, among the first 100 lenders, embraced standards that tried to avoid project finance that could contribute to pollute the environment, to erase forests and to destroy the livelihoods of local people.
But what about the “New Chinese Frontier”?
• By the early 2000’s CALPERS began to implement its policy in emerging equity markets, screening countries and stocks according to their ethical and financial standards. The move is an important step because it has been made by a major operator in financial markets that actively manages up to $1 billion of emerging market assets.
But what about export credit agencies?
MARKETS AND INSTITUTIONS MARKETS AND INSTITUTIONS IN MIDDLE INCOME COUNTRIES:IN MIDDLE INCOME COUNTRIES:
FOREIGN INVESTORS IN EMERGING DEMOCRACIESFOREIGN INVESTORS IN EMERGING DEMOCRACIES
Javier Santiso
Chief Economist & Deputy DirectorOECD Development Centre