The Quality of Political Institutions and Financial Liberalization in Emerging Markets Campbell R....

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The Quality of Political Institutions The Quality of Political Institutions and Financial Liberalization in and Financial Liberalization in

Emerging MarketsEmerging Markets

Campbell R. HarveyDuke University and NBER

Duke University Department of Political ScienceSeptember 13, 2004

1. Overview of Research Program

2. Is Political Risk Priced?

3. Liberalization and Growth

4. Liberalization and Economic Volatility

5. Political Institutions and Risk

Overview of research program

Original motivation:

• How do we evaluate investment projects in different countries?

• Standard models fail – especially in emerging markets [Harvey (1995 RFS)]

• What is “political risk”?

• Is “political risk” priced?

Bonds and equity:

• The promised rate of return on a bond is closely correlated with its “rating”

• Why not try the same idea for equities?

Country Risk Ratings: • Discovered a significant correlation

between equity returns and risk ratings• 1996 “Expected Returns and Volatility in

135 Countries” (JPM)• 1997 “Country Risk in Global Financial

Management” (Monograph)• All coauthored with Erb and Viskanta

Inside the Ratings:

• 1996 “Political Risk, Financial Risk and Economic Risk” (FAJ)

• Higher rating portfolios command higher returns

Political risk

Why would political risk be priced?

• Traditional paradigm. In globally integrated capital markets, the only risk that counts is how investments move with common global factors (political risk is diversifiable and hence not important).

Political risk

• Traditional paradigm. In segmented capital markets, the variance of the home market is important. Local political factors, in so far as they impact the local economy, could be the “fundamental factors” that determine volatility and may be priced.

Political risk

• New paradigms. Even in integrated capital markets, the quality of information could be priced. Political institutions can directly impact the quality of information. For example, government mandating certain disclosure regulations.

Testing importance of political risk

Does political risk impact the discount rate we use to value companies?

• Examine at “implied” cost of capital

• Trading strategies based on realized returns

• At this point, do not control for other information

Political risk is priced …

ICRG Political RiskAll Countries

y = -0.0019x + 0.2614

R2 = 0.4789

50 55 60 65 70 75 80 85 90 95

Rating

t of C

…but driven by emerging markets

ICRG Political RiskEmerging Countries

y = -0.0022x + 0.2886

R2 = 0.4281

50 55 60 65 70 75 80 85 90

Rating

t of C

…not developed countries

ICRG Political RiskDeveloped Countries

y = 0.0005x + 0.0627

R2 = 0.0441

50 55 60 65 70 75 80 85 90 95

Rating

t of C

What type of political risk matters the most?

Factor Points

Percentage of Individual

Percentage of

CompositePoliticalGovernment Stability 12 12 6Socioeconomic Conditions 12 12 6Investment Profile 12 12 6Internal Conflict 12 12 6External Conflict 12 12 6Corruption 6 6 3Military in Politics 6 6 3Religion in Politics 6 6 3Law and Order 6 6 3Ethnic Tensions 6 6 3Democratic Accountability 6 6 3Bureaucracy Quality 4 4 2

Total political points 100 100 50

What type of political risk matters the most?ICRG Political: Government Stability

All Countries

y = -0.0119x + 0.22

R2 = 0.0651

6 7 8 9 10 11

Rating

t of C

ICRG Political: Socioeconomic ConditionsAll Countries

y = -0.0151x + 0.2274

R2 = 0.3737

5 6 7 8 9 10

Rating

t of C

What type of political risk matters the most?ICRG Political: Internal Conflict

All Countries

y = -0.0095x + 0.2178

R2 = 0.3702

5 6 7 8 9 10 11 12 13

Rating

t of C

ICRG Political: Investment ProfileAll Countries

y = -0.016x + 0.2475

R2 = 0.2858

5 6 7 8 9 10

Rating

t of C

ICRG Political: External ConflictAll Countries

y = -0.0084x + 0.2112

R2 = 0.098

7 8 9 10 11 12 13

Rating

t of C

ICRG Political: CorruptionAll Countries

y = -0.0129x + 0.1731

R2 = 0.2568

1 2 3 4 5 6

Rating

ICRG Political: Military in PoliticsAll Countries

y = -0.0142x + 0.1899

R2 = 0.4636

0 1 2 3 4 5 6

Rating

What type of political risk matters the most?ICRG Political: Religion in Politics

All Countries

y = -0.0107x + 0.1757

R2 = 0.2284

0 1 2 3 4 5 6

Rating

ICRG Political: Law and OrderAll Countries

y = -0.0176x + 0.2052

R2 = 0.5273

2 3 4 5 6

Rating

ICRG Political: Ethnic TensionsAll Countries

y = -0.0064x + 0.1502

R2 = 0.0759

1 2 3 4 5 6

Rating

ICRG Political: Democratic AccountabilityAll Countries

y = -0.0133x + 0.1853

R2 = 0.3033

2 3 4 5 6

Rating

ICRG Political: Bureaucratic QualityAll Countries

y = -0.0268x + 0.2081

R2 = 0.5017

0 1 2 3 4

Rating

Changes in sub-categoryP1 P2 P3 P4 P5 P6 P7 P8 P9 P10 P11 P12

P1 0.06 0.08 0.14 0.08 0.05 0.07 0.01 0.08 0.06 0.05 0.01

P2 0.26 0.11 0.05 0.04 0.00 0.02 0.02 0.05 0.03 0.02 0.02

Levels P3 0.61 0.58 0.07 0.11 0.00 0.02 -0.01 0.03 0.02 0.05 -0.01

P4 0.48 0.50 0.49 0.16 0.06 0.09 0.08 0.16 0.20 0.08 0.02

P5 0.34 0.32 0.37 0.63 0.02 0.06 0.04 0.08 0.08 0.04 0.00

P6 0.16 0.49 0.27 0.48 0.34 0.03 0.03 0.07 0.06 0.05 0.04

P7 0.27 0.54 0.48 0.64 0.45 0.60 0.03 0.08 0.06 0.09 0.02

P8 0.17 0.26 0.24 0.48 0.43 0.36 0.41 0.08 0.08 0.00 0.00

P9 0.43 0.57 0.47 0.76 0.49 0.63 0.66 0.40 0.16 0.04 0.02

P10 0.34 0.36 0.31 0.64 0.44 0.40 0.46 0.43 0.58 0.03 0.03

P11 0.22 0.40 0.42 0.48 0.45 0.60 0.62 0.35 0.51 0.35 0.10

P12 0.29 0.65 0.49 0.56 0.40 0.68 0.69 0.30 0.68 0.39 0.65

Correlation of subcomponents of political risk

Predictive hedge portfolios• At end of the month, sort all countries by

political risk rating into high, medium, low• Purchase low rating countries (high risk) and

simultaneously sell high rating countries (low risk)

• Hold for one month• Repeat sort

Predictive Hedge Portfolios Based on Subcategories of Political Risk

-2% -1% 0% 1% 2% 3% 4% 5% 6% 7% 8% 9%

Annual return

Liberalization

Opening your market is a political decision

• Trade liberalization

• Banking liberalization

• Capital account liberalization

• Equity market liberalization

Will mainly concentrate on last two

Liberalization

Equity markets:

1. “Official liberalization”– These dates are based on a detailed chronology

of important regulatory events – http://www.duke.edu/~charvey/chronology.htm

Liberalization

Equity markets:2. “First Sign”• These dates based on the earliest date of {official

liberalization, first ADR and first closed-end fund}

• Example: Thailand – “Official” 1987:09– “First Sign” 1985:07

Liberalization

Equity markets:3. “Capital flow break points”• Analyzed in Bekaert, Harvey and Lumsdaine (JFE

2002, JIMF 2002).

Net Equity Flows to Thailand from US

1983-1

1984-0

1984-1

1985-0

1986-0

1987-0

1987-1

1988-0

1989-0

1990-0

1990-1

1991-0

1991-1

1992-0

1993-0

1994-0

1994-1

1995-0

“Official”

Liberalization

Equity markets:4. “Intensity”• Analyzed in Bekaert, Harvey and Lundblad (JFE

2004)• Investible market capitalization/Total capitalization

Liberalization

Capital account:1. “IMF”• IMF's Annual Report on Exchange Arrangements

and Exchange Restrictions (AREAER)• Analyzed in Bekaert, Harvey and Lundblad (JFE

2004)• Any restriction, then closed

Liberalization

Capital account:2. “Quinn”• Also built from AREAER • However, 0-4 scale measures the intensity of capital

market restrictions

Financial effects

Theory suggests:• Decreased cost of capital• Changes might make country more sensitive to

world shocks• Impact on equity volatility not clear

Impact on Monthly Excess ReturnsCountry Moving From 25th Percentile to Median

Capital Flow Break Points

-0.025

-0.020

-0.015

-0.010

-0.005

sFinancial effects

Impact on CorrelationCountry Moving From 25th Percentile to Median

Official Liberalizations

-0.010.000.010.020.030.040.050.060.070.08

onFinancial effects

Real economic growth

A number of different theories:

• Liberalization implies consumption booms and inefficient investment (crisis literature)

• Liberalization may lead to reduced savings (endogenous growth literature)

• Liberalization may lead to “hot speculative capital” and induce capital flight (Stiglitz & others)

A number of different theories:

• But, if a liberalization reduces the cost of capital, there should be more investment and potentially more GDP growth

Severe endogeneity problem

• Liberalization is not a random event• Liberalizations might be “timed” when

policy makers think prospects are good – and/or when equity markets are overvalued– No simple solution

Preliminary Analysis of Data

VariablePre-

LiberalizationPost-

LiberalizationFully

LiberalizedNever

LiberalizedReal GDP growth (3-year) 0.0160 0.0265 ** 0.0201 -0.0016 ***

Real GDP growth (5-year) 0.0159 0.0276 ***

Real GDP growth (7-year) 0.0153 0.0264 ***

Panel Econometric Framework:

ktititiikkti LibXQy ,,,1980,,,

where yi,t+k,k is real per capita GDP growth between t and t+kQi,1980 is initial GDP,Xi,t represents control variablesLibi,t is a Liberalization indicator variable

Approximately 1% per year over 5-year period

Initial Log(GDP) Gov/GDP

Secondary-School Enrollment

Population Growth Log(Life)

Official Liberalization Indicator

-0.0082 -0.0144 0.0004 -0.1911 0.0975 0.00970.0010 0.0131 0.0048 0.0774 0.0076 0.0020

Results of “classic” regression:

Reasonable Questions: 1. Is the effect robust to the definition of

liberalization? Yes.2. Is the effect driven by certain regions of the world?

No.3. Is it a fluke driven by world economic growth? No.4. Is capital account liberalization driving the equity

market liberalization effect? No.

Other Reasonable Questions: 1. What about fixed effects?

• Liberalization coefficient reduced in size but still highly significant

• What about time effects?• Little impact on Liberalization coefficient

2. What about alternative growth horizons?• Alternative horizons all significant. However, 88% of growth

effect happens in first five years3. Are results sensitive to weighting matrix?

• No.

Other Reasonable Questions: 5. Sensitive to initial 1980 GDP?

• No.6. Is effect a total fluke?

• No. Monte Carlo analysis reveals empirical p-value is less than 0.001

Simultaneous Reforms: 1. Is the effect accounted for by other simultaneous

macroeconomic reforms? No.2. What is the relation between financial

development an equity market liberalization?3. Do legal reforms account for the effect? No.4. Is the effect spuriously induced by banking

reforms? No.

Endogeneity: To effectively deal with endogeneity, we need to

come up with instruments that predict liberalization – but not growth.

A difficult task. Our approach is to attempt to control for growth opportunities.

Endogeneity and growth opportunities

Growth opportunities (Bekaert, Harvey, Lundblad, Siegel (2004))

At any point in time, various world industries have different growth opportunities.

We use global industry PE ratios to proxy for these opportunities.

We then use country industrial weights to come up with a country-specific “exogenous” measure of growth opportunities relative to the world.

Growth opportunities: Growth opportunities predict growth but do not drive

out the liberalization effect.

Growth Opportunties 95 countries 50 countriesOfficial Liberalization Indicator 0.0092 0.0087 Std. error 0.0020 0.0021

Growth Opportunties 0.0106 0.0122 Std. error 0.0038 0.0039

Heterogeneity and institutions

Why do some countries react differently than othersto equity market liberalization? 1. Does the degree of liberalization matter? Yes.2. The relation between financial development and equity

market liberalization3. Is the legal infrastructure important? Yes.4. Quality of institutions a factor? Yes.5. Are economic conditions important? Yes.6. What about investor protection? Important.

4. Quality of institutions

Impact on growth resulting from liberalization

Fully liberalized

From low level of variable

From high level of variable

Direct effect of interaction variable

Number of

countriesQuality of InstitutionsICRGP Quality of Institutions 0.0098 0.0045 0.0129 ** -0.0003 75

Economic volatility

What about the costs of liberalization?

• Liberalization and Development

Perception that speculative foreign capital increases volatility in the real economy (Stiglitz (2000) and Hausmann and Fernandez-Arias (1999)).

• International Risk Sharing No consensus about the extent of the welfare benefits (van Wincoop (1999) and Lewis (1999)).

The costs of liberalization

• Often evidence of increased volatility is specialized to a few high profile examples

• We have a broad cross-country analysis

Economic volatility

Summary of results• When a country opens its equity market to foreign

investment, the volatility of both per capita GDP and consumption growth decreases significantly.

• When the 1998 crisis is included, the effects are weakened for emerging economies, but never indicate significantly higher volatility.

• These results hold for both total and idiosyncratic consumption growth volatility.

Economic volatility

Panel Econometric Framework:

ktititikkti LibXStdev ,,,,,

where Stdevi,t+k,k is the standard deviation of real per capita GDP or consumption growth between t+1 and t+k,Xi,t represents control variables,Libi,t is a Liberalization indicator variable

Economic volatility

Consumption Growth Volatility and Equity Market Liberalization

uelaBraz

Tunisi

Jamaic

Greece

Icelan

Colombia

Cote d'

Ivoire

South A

Bangla

Pakist

Average

Portugal

Thaila

Botswan

Philipp

Sri Lan

Trinid

Nigeri

Post-Pre Consumption Growth Volatility

Standard deviation

AveragesPre-

liberalizationPost-

liberalization

Equal-weighted 0.052 0.045GDP-weighted 0.047 0.033

Countries with increased volatility 26Countries with decreased volatility 14

Economic volatility

Questions: 1. What is the role of capital account openness? Does it make a

difference if the capital account is open or closed? YES2. Robust to dating of Liberalization? YES3. Business cycle effect? NO4. Do other simultaneous reforms explain the volatility effect?

Economic volatility

4. Simultaneous reforms: Institutions

Quality of Institutions -0.0585 -0.0205 Std. error 0.0108 0.0102Official Liberalization Indicator -0.0082 -0.0026 Std. error 0.0035 0.0031

Economic volatility

Why does consumption volatility react differently across different countries?

1. Financial development2. Legal infrastructure3. Political Environment4. Investment conditions / protection

1. Financial development

Impact on volatility resulting from liberalization

Fully Liberalized

from low level of variable

from high level of variable

Direct effect of

interaction variable

Number of countries

Financial developmentPrivate Credit -0.0429 *** 0.0060 -0.0130 *** -0.0036 95Turnover -0.0077 ** 0.0052 -0.0010 -0.0061 *** 50

2. Legal infrastructure

Fully Liberalized

Direct effect of

Number of countries

Legal environmentFrench vs. English law -0.0378 *** -0.0022 -0.0055 95Other vs. English law -0.0378 *** -0.0012 -0.0055 95Not Latin vs. Latin -0.0349 *** -0.0035 0.0101 *** 0.0127 *** 95Judicial efficiency -0.0117 ** 0.0047 -0.0105 *** 0.0354 *** 47Speed of process (combined) -0.0281 *** -0.0033 -0.0065 -0.0002 69

3. Political environment

Fully Liberalized

Direct effect of

Number of countries

Political EnvironmentICRG Political Index -0.0264 *** 0.0068 -0.0141 *** -0.0509 *** 75

Political Conditions -0.0206 *** -0.0075 -0.0027 -0.0434 *** 75Quality of Institutions -0.0170 *** 0.0049 -0.0049 *** -0.0567 *** 75Socio-Economic -0.0330 *** -0.0045 -0.0056 -0.0130 * 75Conflict -0.0318 *** -0.0008 -0.0111 *** 0.0027 75

4. Economic conditions / investor protection

Fully Liberalized

Direct effect of

Number of countries

Investment conditions/protectionICRGE -0.0323 *** 0.0036 -0.0062 *** -0.0542 *** 75Social Security -0.0115 *** 0.0048 -0.0020 ** -0.0417 *** 58Anti-director rights -0.0055 ** 0.0121 -0.0021 *** -0.0039 * 47Creditor rights -0.0041 * -0.0012 0.0028 0.0037 * 45Accounting standards -0.0021 -0.0032 0.0015 -0.0189 *** 39

Predicting Equity Market Liberalization68 liberalizing and segmented countries

Probit Est. Std. errorConstant 13.12 12.60Initial Log(GDP) -0.80 0.34Gov/GDP -2.51 3.29Secondary-School Enrollment 6.96 2.69Population Growth 19.05 29.53Log(Life) -3.43 3.23Past Growth -1.74 8.37Growth Opportunities -18.39 7.61Past Volatility -13.58 9.87Private Credit 3.79 1.80ICRG Political Index 5.46 2.46

Quality of Institutions 5.81 1.84

Conflict 2.25 1.91

Social Security (41 countries) 0.65 0.39

Predicting equity market liberalization

Conclusions

• Financial liberalization spurs growth by 1% per annum over the five years

• Equity market liberalization does not increase economic volatility – or idiosyncratic volatility

• Survives a battery of robustness experiments

• Liberalization effect not spuriously accounted for by a host of other events such as macro-economic reforms

Conclusions

• Financial liberalization has a very important economic effect

Conclusions

Gov/GDP 75th to 50th

Enrollment 25th to 50th

Pop Growth 75th to 50th

Life Exp. 25th to 50th

Liberalization

Total Growth = 3.02%

•Consider economic impact of improvements plus a equity market liberalization

Liberalization

Conclusions

Real Effects of Equity Market Liberalization

Future and on-going research

• Financial development

• Growth opportunities

• Liquidity and asset pricing

• The sequencing of liberalizations

The Quality of Political Institutions and Financial Liberalization in Emerging Markets Campbell R....

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