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 $)

-50

0

50

100

150

200

250

300

70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 0 1 2E-50

0

50

100

150

200

250

300 Latin America

East Europe and Middle East

Asia

Total emerging markets

Source: IIF, IMF, 2002.

• FDI total flows grew tenfold and commercial flows grew twice as much.

Latin America also profited from this boom of capital inflow ...

Net private capital flows towards emerging markets (billions of US $)

-100

-50

0

50

100

150

70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 0 2E-60

-10

40

90

140Net official flowss

Other investments (bank flows,etc.)Net portfolio flows

FDI flows

Flujos de capitales totales, netos

Source: IIF, IMF, 2002.

-3

-2

-1

0

1

2

3

4

5

6

-50 -40 -30 -20 -10 0 10 20 30

Change in capital flows (mM$)

GD

P g

row

th (

%)

99

00

01

02

… which is correlated to growth

Period 1980-2002

Source: BBVA based on IMF database

1. Are Foreign Direct Investors Politically Correct?

Low Confidence High Confidence

ChinaUnited States

MexicoPoland

GermanyIndia

United KingdomRussiaBrazilSpain

FranceItaly

Czech RepublicCanada

JapanThailandHungary

South KoreaAustralia

TaiwanVietnam

Hong KongMalaysia

TurkeyIndonesia

123456789

10111213141516171819202122232425

(1)(2)(9)(11)(4)(15)(3)(17)(13)(7)(5)(6)(14)(8)(12)(20)(16)(21)(10)(24)(33)(18)(42)(29)(31)

( )= 2002 Values Calculated on a 0 to 3 Scale

Source: A.T. Kearney, 2003

FDI Confidence Index 2003, top 25

Foreign Direct Investors Perceptions:

Most attractive FDI destinations 2003

Least Attractive

Global InvestorsHighly

Attractive

0

0,5

1

1,5

2 Asia

Europe

NorthAmerica

LatinAmerica

Africa/ &MiddleEast

Jan 2000

Feb 2001

Sept 2002

Dec 1998

June 1999

FDI Index Score

Source: A.T. Kearney

Sept 2003

Latin America falls behind

Asia

Asia surpasses Europe

Asia has overtaken both Latin America and Europe as a regional FDI destination

Source: A.T. Kearney, UNCTAD

China28%

Rest of Developing

World52%

Mexico7%

Brazil9%

Poland2%India

2%

The Emerging Giants receive a large share of FDI flowing to the

developing world

The Emerging Giants receive a large share of FDI flowing to the

developing world

2002 2002

• Market Size• Market Growth/Potential• Production/Labor Costs• Access to Export Markets• Competitor Presence• Availability of M&A Targets• Financial/Economic Stability• Political/Social Stability• Tax Regime• Infrastructure• Transparency• Highly Educated Workforce • Quality of Life

Thirteen attributes influencing FDI decisions were benchmarked across

these markets

Thirteen attributes influencing FDI decisions were benchmarked across

these markets

The Emerging Giants – China, Brazil, Mexico, India, and Poland

Percentage likelihood of investing in China over these other markets (percentage difference in FDI Index

scores)

Source: A.T. Kearney

17%

34%

25%

12%

67%73%

90%83%86% 87% 90%

109%

0%

20%

40%

60%

80%

100%

120%

Mexico Poland India Brazil

2001

2002

2003

China’s lead over most emerging market destinations has

strengthened

0%

20%

40%

60%

80%

100%Market Size

Market Growth/Potential

Production/Labor Costs

Access to Export MarketsCompetitor Presence

Availability of M&A Targets

Financial/Economic Stability

China Brazil Mexico India Poland

Relative attractiveness of various markets for selected aspects

(weighted score of country rankings)

Relative attractiveness of various markets for selected aspects

(weighted score of country rankings)

China displays a comparative advantage in most FDI attractive

aspects

Source: A.T. Kearney

Source: A.T. Kearney

0% 20% 40% 60% 80% 100%

Brazil

India

Mexico

China

Poland

Political/Social Stability Financial/Economic Stability

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

2 Transparency * 12,50% Freedom House, IASB, Oxford Analytica, Salomon

3 Productive Labor Practices * 12,50% Verite

4 Market Liquidity and Volatility 12,50% S&P Emerging Stock Markets Factbook, Wilshire Compass

5 Market regulation/Investor protection 18,75% Global Competitiveness Report, NBER

6 Capital market openness 12,50% The Heritage Foundation's Index of economic Freedom

7 Settlement proficiency 12,50% Salomon Smith Barney Guide to World Equtiy Markets, Brinson Partners

8 Transaction costs 6,25% Brinson Partners

Note *: The three country macro-factors are 1, 2, and 3.The others are market macro-factors.

Source: Based on Calpers and Wilshire, 2002.

An Example: Calpers Screening of Developing Countries

Calpers - Wilshire Macro-Factors Scores

Pol. Stability Transparency Labor Pratices Market Liquidity Market Regulation Cap. Mark. Openness Settle. Proficiency Trans. Costs Wilshire Score

1 Argentina 2 3 3 2 3 3 2 3 2,632 Taiwan 3 2 2 3 3 2 3 2 2,563 Israel 2 1 3 2 3 3 3 2 2,444 South Korea 3 3 3 3 1 2 3 2 2,445 Chile 3 2 3 1 3 3 2 1 2,386 Hungary 3 3 3 3 11 3 1 3 2,387 Poland 3 2 3 3 2 3 2 2 2,318 Peru 2 3 2 1 2 3 2 3 2,199 Turkey 1 1 2 3 2 3 3 3 2,19

20 Brazil 2 2 2 2 3 1 2 3 2,1311 Mexico 2 2 2 3 1 2 3 3 2,1312 South Africa 2 2 3 1 3 2 1 3 2,1313 Czech Rep. 3 3 3 1 1 3 1 2 2,0614 India 2 2 1 3 2 1 1 2 1,7515 Jordan 2 1 2 2 1 2 2 3 1,7516 Philippines 2 3 2 1 2 1 1 2 1,7517 Thailand 2 1 2 1 1 2 3 1 1,6318 China 1 1 1 3 1 1 3 2 1,5619 Egypt 2 2 1 2 1 1 2 2 1,5620 Malaysia 1 1 1 2 2 1 2 3 1,5621 Pakistan 1 1 1 1 2 2 2 2 1,522 Colombia 1 1 2 1 1 3 1 2 1,4423 Indonesia 1 1 1 1 1 2 2 2 1,3124 Morocco 1 1 1 2 1 2 1 2 1,3125 Sri Lanka 1 1 1 1 1 2 1 2 1,3126 Venezuela 1 2 2 1 1 2 1 2 1,3127 Russia 1 1 1 2 1 1 1 2 1,19

Source: Calpers and Wilshire Associates, 2002.

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

0,94

0,96

0,98

1

1,02

1,04

1,06

1,08

1,1

1,12

1,14

1,16

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

Source: Frieden, Ghezzi y Stein, 2001

Country`s Total Elections 1 Colombia 13 1989 172 Costa Rica 11 1990 143 Guatemala 11 1991 34 Ecuador 10 1992 05 Chile 10 1993 106Peru 10 1994 187 Honduras 10 1995 68 Paraguay 9 1996 89Brazil 9 1997 7

10 El Salvador 9 1998 1511Republica Dom. 9 1999 1212 Uruguay 9 2000 1113Mexico 9 2001 414 Argentina 8 2002 1315 Nicaragua 8 2003 816Panama 8 2004 617 Venezuela 8 2005 518 Bolivia 7 2006 11

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

Source: Datafolha, JP Morgan

1994 April-October 0,92

1998 March-September 0,68

2002 (Lula) January-August 0,54 January-May 0,98

2002 (Lula + Ciro) January-August 0,88 January-May 0,97

Significance level: 0,50 (1994); 0,63 (1998); 0,60 (2002)

Cross-Correlation between the Brazil-Emerging Debt Spreadand Popularity Vote for Lula

In 2003: Wall Street ‘Mea Culpa’ and  ’Love Affair’ With Lula

Best Performers in Equity Markets in 2003

Best Yearly Performance (in %) *

Argentina 121Thailand 118China 117India 102

Brazil 90

Worst

Venezuela 20Finland 21Malaysia 21Netherlands 24Poland 24

Source: Thomson DatastreamNote *: In dollar terms.

Emerging Markets Total Returns

EMBIG Divers. EMBIG EMBI+ S&P 500 US Treas

1994 -19,28% -18,35% -18,93% 1,32% -2,90%1995 27,34% 26,38% 26,78% 37,58% 17,34%1996 37,75% 35,23% 39,30% 22,96% 2,94%1997 10,81% 11,95% 13,02% 33,36% 10%1998 -8,11% -11,54% -14,35% 28,58% 10,25%1999 19,56% 24,18% 25,97% 21,02% -2,88%2000 12,68% 14,41% 15,66% -8,13% 13,93%2001 9,70% 1,36% -0,79% -12,81% 6,55%2002 13,65% 13,11% 14,24% -22,10% 12,21%

2003 * 18,90% 22,08% 24,88% 22,27% 1,49%

Average 11,25% 10,73% 11,17% 10,59% 6,74%Annual Return

Source: JP Morgan, December 2003.Note * : Returns until November 2003.

Lula Light: Institutional Reforms and Confidence Building

Brazil Reform Scorecard in April 2003 According to Merrill Lynch

Reform Change Recent Developments Quality Score (1) Progress Score Reform Score

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

Reform Change Recent Developments Quality Score Progress Score Reform Score

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

Emerging Markets Serial Defaulters

Argentina 4 25,60% 0 15,8Brazil 7 25,60% 7 39,9Chile 3 23,30% 17 66,1Colombia 7 38,60% 57 38,7Mexico 8 46,90% 12 59Venezuela 9 38,60% 4 30,6Turkey 6 16,50% 20 33,8

Emerging Markets with No Defaults

India 0 0 47,3Korea 0 0 65,6Malaysia 0 0 57,7Singapore 0 0 86,1Thailand 0 0 51,9

61,7OECD Industrial Economies

United States 0 0 93,1Austarlia 0 0 84,5New Zealand 0 0 81,2

Source: Reinhart, Rogoff and Savastano, August 2003.

Note*: Country Risk are on a scale from 0 to 100, where 1000 indicatesthe lowest probability of default on government bond.

A Bias for Hope: The Exit From Institutional Traps is

PossibleExternal Debt Defaults in Europe before the Twentieth Century

Number of Defaults Years of Defaults Number of Defaults Years of Defaults Total Defaults1501-1800 1801-1900

Spain 6 1557, 1575, 1596 7 1820, 1831, 1834 131607, 1627, 1647 1851, 1867, 1872, 1882

France 8 1558, 1624, 1648, 1661 n.a. 81701, 1715, 1770, 1788

Portugal 1 1560 5 1837, 1841, 1845 61852, 1890

Germany 1 1683 5 1807, 1812, 1813 61814, 1850

Austria n.a. n.a. 5 1802, 1805, 1811 51816, 1868

Greece n.a. n.a. 4 1826, 1843, 1860, 1893 4Bulgaria n.a. n.a. 2 1886, 1891 2Holland n.a. n.a. 1 1814 1Russia n.a. n.a. 1 1839 1

Total 16 30 46

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

Casa de AméricaMadrid, 8-9 June 2006