Cracking the Emerging Markets Enigma FINANCIAL MANAGEMENT ASSOCIATION Survey and Synthesis Series Asset Management: A Systematic Approach to Factor Investing Andrew Ang Asset Pricing and Portfolio Choice Theory Kerry E. Back Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing Hersh Shefrin Beyond the Random Walk: A Guide to Stock Market Anomalies and Low-Risk Investing Vijay Singal Consumer Credit and the American Economy Thomas A. Durkin, Gregory Elliehausen, Michael E. Staten, and Todd J. Zywicki Debt Management: A Practitioner’s Guide John D. Finnerty and Douglas R. Emery Dividend Policy: Its Impact on Firm Value Ronald C. Lease, Kose John, Avner Kalay, Uri Loewenstein, and Oded H. Sarig Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation, 2nd Edition Richard O. Michaud and Robert O. Michaud Last Rights: Liquidating a Company Dr. Ben S. Branch, Hugh M. Ray, and Robin Russell Managing Pension and Retirement Plans: A Guide for Employers, Administrators, and Other Fiduciaries August J. Baker, Dennis E. Logue, and Jack S. Rader Managing Pension Plans: A Comprehensive Guide to Improving Plan Performance Dennis E. Logue and Jack S. Rader Mortgage Valuation Models: Embedded Options, Risk, and Uncertainty Andrew Davidson and Alex Levin Real Estate Investment Trusts: Structure, Performance, and Investment Opportunities Su Han Chan, John Erickson, and Ko Wang Real Options: Managing Strategic Investment in an Uncertain World Martha Amram and Nalin Kulatilaka Real Options in Theory and Practice Graeme Guthrie Slapped by the Invisible Hand: The Panic of 2007 Gary B. Gorton Survey Research in Corporate Finance: Bridging the Gap between Theory and Practice H. Kent Baker, J. Clay Singleton, and E. Theodore Veit The Financial Crisis of Our Time Robert W. Kolb The Search for Value: Measuring the Company’s Cost of Capital Michael C. Ehrhardt Too Much Is Not Enough: Incentives in Executive Compensation Robert W. Kolb Trading and Exchanges: Market Microstructure for Practitioners Larry Harris Truth in Lending: Theory, History, and a Way Forward Thomas A. Durkin and Gregory Elliehausen Value Based Management with Corporate Social Responsibility, 2nd Edition John D. Martin, J. William Petty, and James S. Wallace Valuing the Closely Held Firm Michael S. Long and Thomas A. Bryant Working Capital Management Lorenzo Preve and Virginia Sarria-Allende Cracking the Emerging Markets Enigma G. Andrew Karolyi 1 1 Oxford University Press is a department of the University of Oxford. It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide. Oxford New York Auckland Cape Town Dar es Salaam Hong Kong Karachi Kuala Lumpur Madrid Melbourne Mexico City Nairobi New Delhi Shanghai Taipei Toronto With offices in Argentina Austria Brazil Chile Czech Republic France Greece Guatemala Hungary Italy Japan Poland Portugal Singapore South Korea Switzerland Thailand Turkey Ukraine Vietnam Oxford is a registered trademark of Oxford University Press in the UK and certain other countries. Published in the United States of America by Oxford University Press 198 Madison Avenue, New York, NY 10016 © Oxford University Press 2015 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, by license, or under terms agreed with the appropriate reproduction rights organization. Inquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above. You must not circulate this work in any other form and you must impose this same condition on any acquirer. Library of Congress Cataloging-in-Publication Data Karolyi, G. Andrew. Cracking the emerging markets enigma / G. Andrew Karolyi. pages cm.— (Financial Management Association survey and synthesis series) Includes bibliographical references and index. ISBN 978–0–19–933662–3 (alk. paper) 1. Investments, Foreign—Developing countries. 2. Investments—Developing countries. I. Title. HG5993.K37 2015 332.67′3091724—dc23 2014046283 1 3 5 7 9 8 6 4 2 Printed in the United States of America on acid-free paper { CONTENTS } Preface vii Acknowledgments xi PART I Understanding the Risks in Emerging Markets 1. Accepting the Challenge 3 2. The Emerging Market Landscape 21 3. A Primer on Empirical Methodology 36 PART II Building the Emerging Markets Risk Indicators 4. Market Capacity Constraints 47 5. Operational Inefficiencies 64 6. Foreign Accessibility Restrictions 85 7. Corporate Opacity 107 8. Limits on Legal Protections 127 9. Political Instability 150 PART III Validating the Risk Indicators 10. Do the Emerging Market Risk Indicators Work? 173 11. Making Sense of the Emerging Market Swoon of 2013 195 PART IV The Emerging Markets Enigma Cracked? 12. Final Remarks and a Few Cautions 209 Data Appendices 215 Notes 241 Bibliography 271 Index 285 { PREFACE } During World War II, the British Government Code and Cypher School at Bletchley Park built up an extensive cryptanalysis team designed to read sub- stantial amounts of secret Morse-coded radio communications of the Axis powers that had been enciphered using so-called Enigma machines. This mas- sive effort over a five-year period yielded military intelligence that was con- sidered by western Supreme Allied Commander Dwight Eisenhower to have been decisive to the Allied victory. The Enigma machines were portable, plug board-equipped cipher machines with rotor scramblers, which made the ciphers virtually unbreakable as long as good operating and proper enforcement pro- cedures were followed. Alan Turing, a Cambridge University mathematician and widely considered the father of computer science and artificial science, provided much of the analytical thinking that led to the design of the Bombe machines—precursors of the modern-day computer—that eventually broke the Enigma code. Much has been written and told about Bletchley Park, Turing, and the Enigma codebreaking, including a serious treatise by Frederick William Winterbotham published in 1974 by Orion Books titled The Ultra Secret: The Inside Story of Operation Ultra, Bletchley Park, and Enigma. The “Ultra” in Winterbotham’s title was the designation adopted by British military intelligence for the wartime signals intelligence obtained by breaking encrypted enemy communications. This serious book inspired, in turn, the 1986 London play by Hugh Whitemore, Breaking the Code, which focused on Alan Turing himself; another wonderful fictional thriller by Robert Harris titled Enigma (1995, Arrow Books), and the 2001 film by the same name starring Kate Winslet and Dougray Scott (Jagged Films). The 2014 Black Bear Pictures release of The Imitation Game, the new- est installment, will undoubtedly draw even more attention. Bletchley Park is today a heritage site where visitors can see the original code-breaking huts and blocks. While I would love to envision myself as a modern-day Enigma code-breaker tasked with devising an understanding of the risks associated with investing in emerging markets, I know I am not worthy of the comparison. But this is the goal of my book. And I would be remiss in failing to give due credit to the men and women of Bletchley Park who inspired my title for the project. I am fascinated by their story and feel lucky to have visited the site, seen the actual German Navy 4-rotor Enigma machines, and even pulled the start levers of one of Turing’s rebuilt Bombes that cracked the code. viii Preface What Is This Book About? This book develops a rigorous, comprehensive, and practical framework in which to evaluate the opportunities—and, more importantly, the risks—of investing in emerging markets. It is rigorous in that it is built on a foundation of sound academic research on foreign direct and portfolio capital flows and the principles underlying international finance and economics. The framework is comprehensive in that it incorporates in an empirically coherent framework multiple dimensions of the potential risks that a prospective corporation or investor faces walking into those markets. These dimensions of risk reflect the uneven quality and fragility of the various institutions designed to assure integ- rity in the functioning of the country’s capital markets. Finally, the framework is practical, as it distills these various dimensions of risk into an internally con- sistent scoring system that ranks emerging markets by each dimension of risk and overall across all dimensions. Philosophically, this book posits that what fundamentally characterizes emerging markets are not the high rates of actual economic growth, but the even higher rates of potential economic growth that are hampered by the underdeveloped capital markets needed to finance them. The limited capac- ity of the financial markets in those countries, mandates active engagement of multinational corporations and foreign investors to help fund the shortfall. But these capital flows are stunted in turn by operational inefficiencies, restrictions on foreign participation, problems of poor governance and transparency rules, weak legal protections for investors, and political instability. These are the six dimensions of risk that comprise the scoring system around which the book is built and that will constitute its main chapters. To enable its practical use, the book will also feature recent case studies of corporations and investors that have done deals in many of the emerging markets that embody my risk scoring system. The case studies focus on recent financial decisions involving corporations from emerging markets issuing secu- rities to fund their businesses, global corporations seeking acquisition opportu- nities in emerging markets, cross-border asset sales, joint public-private project financing of infrastructure investments, and many other situations. They are relatively recent events, and have been used as teaching cases in my course on emerging markets at Cornell University. A case study will be seamlessly inte- grated into the chapter associated with the dimension of risk it is designed to showcase. The primary force behind this book project was my consulting engagement with Dimensional Fund Advisors, a major US-based asset management firm with over $325 billion in assets under management (as of early 2014). In 2005, they hired me for a multiyear project to help determine objective criteria by which they should judge the countries into which they were deploying their Preface ix investment strategies and client monies—and, more importantly, those into which they did not. Like so many managers with global mandates, and especially in emerging markets, the firm was concerned with market capacity constraints, operational inefficiencies, foreign investability restrictions, and the quality of legal protections for minority investors, corporate governance, and disclosure issues. For Dimensional, it was important that these criteria be well grounded in sound academic research on international markets. Fortunately, much of my own research program during the preceding 20 years had been focused on one or the other of these various dimensions of risk toward understanding their consequences for investors or corporations. I am glad that Dimensional gave me the green light to build on, extend, and update the core elements of the original consultative white paper from 2006 for this book today. How Is the Book Organized? The book has four parts. The first part, which involves three separate chap- ters, sets the stage. The opening chapter is called “Accepting the Challenge” (which is how I responded to Dimensional in 2005), and gives a complete over- view of the book. It gives the reader a taste of the six different indicators, how they are built, what the overall findings are across the countries that consti- tute my emerging market set, and how I try to validate their usefulness. This is my one-stop-shopping chapter; if you read only one, then this is the one to pick. The other two chapters justify the set of emerging market countries I will study (“The Emerging Market Landscape,” Chapter 2) and describe in detail the multivariate statistical methodology I used to distill the data into a single index for each risk indicator. Some readers may want to skip “A Primer on Methodology” (Chapter 3) to get straight to the results, but I strongly recom- mend that they do not. The methods define the outcomes and I make strategic choices that deserve scrutiny. Part II builds the emerging market risk indicators one by one, with chapters corresponding to each of the six risk indicators. They follow the same methodi- cal structure of defining the category, highlighting the extensive research that lies at its core, describing the data sources that I integrate into the statistical analysis, and exhibiting the resulting scores. I always wrap the analysis in each chapter around one of the case studies to bring the key concepts alive. In order to validate the risk indicators I turn to the penultimate Part III of the book, in which I put some tough tests before them. Specifically, I obtain data on foreign portfolio holdings and net foreign portfolio flows by global investors into emerging markets, to see if one can reconcile how they might choose to do so with the risk indicators that I built. Chapter 10 offers up evi- dence that they work quite well.