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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
2
Plan
1. Overview of Research Program
2. Is Political Risk Priced?
3. Liberalization and Growth
4. Liberalization and Economic Volatility
5. Political Institutions and Risk
3
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?
4
Overview of research program
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?
5
Overview of research program
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
6
Overview of research program
Inside the Ratings:
• 1996 “Political Risk, Financial Risk and Economic Risk” (FAJ)
• Higher rating portfolios command higher returns
7
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).
8
Political risk
Why would political risk be priced?
• 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.
9
Political risk
Why would political risk be priced?
• 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.
10
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
11
Political risk is priced …
ICRG Political RiskAll Countries
y = -0.0019x + 0.2614
R2 = 0.4789
0%
5%
10%
15%
20%
25%
50 55 60 65 70 75 80 85 90 95
Rating
Cos
t of C
apit
al
12
…but driven by emerging markets
ICRG Political RiskEmerging Countries
y = -0.0022x + 0.2886
R2 = 0.4281
0%
5%
10%
15%
20%
25%
50 55 60 65 70 75 80 85 90
Rating
Cos
t of C
apit
al
13
…not developed countries
ICRG Political RiskDeveloped Countries
y = 0.0005x + 0.0627
R2 = 0.0441
0%
2%
4%
6%
8%
10%
12%
14%
50 55 60 65 70 75 80 85 90 95
Rating
Cos
t of C
apit
al
14
What type of political risk matters the most?
Factor Points
Percentage of Individual
Index
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
15
What type of political risk matters the most?ICRG Political: Government Stability
All Countries
y = -0.0119x + 0.22
R2 = 0.0651
0%
5%
10%
15%
20%
25%
6 7 8 9 10 11
Rating
Cos
t of C
apit
al
16
What type of political risk matters the most?
ICRG Political: Socioeconomic ConditionsAll Countries
y = -0.0151x + 0.2274
R2 = 0.3737
0%
5%
10%
15%
20%
25%
5 6 7 8 9 10
Rating
Cos
t of C
apit
al
17
What type of political risk matters the most?ICRG Political: Internal Conflict
All Countries
y = -0.0095x + 0.2178
R2 = 0.3702
0%
5%
10%
15%
20%
25%
5 6 7 8 9 10 11 12 13
Rating
Cos
t of C
apit
al
18
What type of political risk matters the most?
ICRG Political: Investment ProfileAll Countries
y = -0.016x + 0.2475
R2 = 0.2858
0%
5%
10%
15%
20%
25%
5 6 7 8 9 10
Rating
Cos
t of C
apit
al
19
What type of political risk matters the most?
ICRG Political: External ConflictAll Countries
y = -0.0084x + 0.2112
R2 = 0.098
0%
5%
10%
15%
20%
25%
7 8 9 10 11 12 13
Rating
Cos
t of C
apit
al
20
What type of political risk matters the most?
ICRG Political: CorruptionAll Countries
y = -0.0129x + 0.1731
R2 = 0.2568
0%
5%
10%
15%
20%
25%
1 2 3 4 5 6
Rating
Cos
t of
Cap
ital
21
What type of political risk matters the most?
ICRG Political: Military in PoliticsAll Countries
y = -0.0142x + 0.1899
R2 = 0.4636
0%
5%
10%
15%
20%
25%
0 1 2 3 4 5 6
Rating
Cos
t of
Cap
ital
22
What type of political risk matters the most?ICRG Political: Religion in Politics
All Countries
y = -0.0107x + 0.1757
R2 = 0.2284
0%
5%
10%
15%
20%
25%
0 1 2 3 4 5 6
Rating
Cos
t of
Cap
ital
23
What type of political risk matters the most?
ICRG Political: Law and OrderAll Countries
y = -0.0176x + 0.2052
R2 = 0.5273
0%
5%
10%
15%
20%
25%
2 3 4 5 6
Rating
Cos
t of
Cap
ital
24
What type of political risk matters the most?
ICRG Political: Ethnic TensionsAll Countries
y = -0.0064x + 0.1502
R2 = 0.0759
0%
5%
10%
15%
20%
25%
1 2 3 4 5 6
Rating
Cos
t of
Cap
ital
25
What type of political risk matters the most?
ICRG Political: Democratic AccountabilityAll Countries
y = -0.0133x + 0.1853
R2 = 0.3033
0%
5%
10%
15%
20%
25%
2 3 4 5 6
Rating
Cos
t of
Cap
ital
26
What type of political risk matters the most?
ICRG Political: Bureaucratic QualityAll Countries
y = -0.0268x + 0.2081
R2 = 0.5017
0%
5%
10%
15%
20%
25%
0 1 2 3 4
Rating
Cos
t of
Cap
ital
27
What type of political risk matters the most?
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
28
What type of political risk matters the most?
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
29
What type of political risk matters the most?
Predictive Hedge Portfolios Based on Subcategories of Political Risk
-2% -1% 0% 1% 2% 3% 4% 5% 6% 7% 8% 9%
P1
P2
P3
P4
P5
P6
P7
P8
P9
P10
P11
P12
Annual return
30
Liberalization
Opening your market is a political decision
• Trade liberalization
• Banking liberalization
• Capital account liberalization
• Equity market liberalization
Will mainly concentrate on last two
31
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
32
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
33
34
35
36
Liberalization
Equity markets:3. “Capital flow break points”• Analyzed in Bekaert, Harvey and Lumsdaine (JFE
2002, JIMF 2002).
37
Net Equity Flows to Thailand from US
0
100
200
300
400
500
600
700
800
1983-1
0
1984-0
5
1984-1
2
1985-0
7
1986-0
2
1986-0
9
1987-0
4
1987-1
1
1988-0
6
1989-0
1
1989-0
8
1990-0
3
1990-1
0
1991-0
5
1991-1
2
1992-0
7
1993-0
2
1993-0
9
1994-0
4
1994-1
1
1995-0
6
“Official”
Liberalization
38
Liberalization
Equity markets:4. “Intensity”• Analyzed in Bekaert, Harvey and Lundblad (JFE
2004)• Investible market capitalization/Total capitalization
39
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
40
Liberalization
Capital account:2. “Quinn”• Also built from AREAER • However, 0-4 scale measures the intensity of capital
market restrictions
41
Financial effects
Theory suggests:• Decreased cost of capital• Changes might make country more sensitive to
world shocks• Impact on equity volatility not clear
42
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
0.000
0.005
0.010
0.015
Cha
nge
in e
xces
s re
turn
sFinancial effects
43
Impact on CorrelationCountry Moving From 25th Percentile to Median
Official Liberalizations
-0.010.000.010.020.030.040.050.060.070.08
Cha
nge
in c
orre
lati
onFinancial effects
44
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)
45
A number of different theories:
• But, if a liberalization reduces the cost of capital, there should be more investment and potentially more GDP growth
Real economic growth
46
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
Real economic growth
47
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 ***
Real economic growth
48
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
Real economic growth
49
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:
Real economic growth
50
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.
Real economic growth
51
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.
Real economic growth
52
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
Real economic growth
53
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.
Real economic growth
54
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
55
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.
Endogeneity and growth opportunities
56
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
Endogeneity and growth opportunities
57
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.
58
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
59
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)).
60
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
61
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
62
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
63
Consumption Growth Volatility and Equity Market Liberalization
-0.17
-0.12
-0.07
-0.02
0.03
0.08
0.13
0.18
Peru
Jorda
n
Zimba
bwe
Venez
uelaBraz
il
Tunisi
a
Jamaic
aIsr
ael
Kenya
Greece
Icelan
d
Colombia
Mau
ritiu
s
Mex
ico
Cote d'
Ivoire
Japa
n
South A
frica
Bangla
desh
Pakist
an
Average
Egypt
Portugal
Malt
a
Thaila
nd
Turke
y
Moro
cco
Chile
Botswan
a
Korea
Philipp
ines
Sri Lan
ka
New Z
ealan
d
Indo
nesia
Spain
Ecuad
orIn
dia
Trinid
ad an
d Tob
ago
Mala
ysia
Argen
tina
Nigeri
a
Ghana
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
64
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?
NO
Economic volatility
65
4. Simultaneous reforms: Institutions
95 40
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
66
Heterogeneity and institutions
Why does consumption volatility react differently across different countries?
1. Financial development2. Legal infrastructure3. Political Environment4. Investment conditions / protection
67
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
Heterogeneity and institutions
68
2. Legal infrastructure
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
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
Heterogeneity and institutions
69
3. Political environment
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
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
Heterogeneity and institutions
70
4. Economic conditions / investor protection
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
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
Heterogeneity and institutions
71
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
72
Conclusions
• Financial liberalization spurs growth by 1% per annum over the five years
• Equity market liberalization does not increase economic volatility – or idiosyncratic volatility
73
• Survives a battery of robustness experiments
• Liberalization effect not spuriously accounted for by a host of other events such as macro-economic reforms
Conclusions
74
• Financial liberalization has a very important economic effect
Conclusions
75
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
76
Real Effects of Equity Market Liberalization
Future and on-going research
• Financial development
• Growth opportunities
• Liquidity and asset pricing
• The sequencing of liberalizations