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Yale School of Management

Emerging Market Finance:

Lecture 6: Free Press as an External Corporate Governance Institution

Can you develop a capital market without a free press?How should you invest in an opaque market?What about corporate finance strategies?

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Yale School of Management

Rule of Law and Capital Markets

图七：法治程度和证券市场发展

法治最好组

法治最好组

法治中等组

法治中等组

法治最差组

法治最差组

0

20

40

60

80

/ GNP %债市总值 的比（ ） 每百万人上市公司数

Country Groups based on the Rule of Law Index

BestMiddle

Worst BestMiddle

Worst

Bond Mkt Value/GNP Ratio (%)

# of Public Companies per million of population

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Yale School of Management

Press Freedom and Capital Markets

7. 32%

16. 46%

28. 81%

0%

10%

20%

30%

40%

Cap

Mkt

Valu

e/GD

P Ra

tio

Countries with the press not free

Countries with free press

Press freedom rankings: 1972

Capital market data: 1995

Sample: 60 countries

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Yale School of Management

Why is it so hard?

Trading apples and oranges

vs.

Trading stocks and bond

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Yale School of Management

Degree of stock price

comovements across

countires: why?

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Yale School of Management

% of stock returns

explainable by market returns

across countries:

why?

7

Yale School of Management

Why such a big difference in stock comovement?

Consider a simple model: two firms traded: A & BBoth A & B disclose that their future is “superb”.

But, in fact, only one of them is “good”.Without a free press or proper disclosure law

(enforcement), investors can only guess: chance of A being “good” is .

How should investors invest if = 50%? Will investors be better off if | - 0.5 | is made hig

her?

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Yale School of Management

The U.S. Experience: fraction of stocks moving in same direction

Maxf: US market

0.5

0.55

0.6

0.65

0.7

0.75

0.8

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Yale School of Management

The U.S. Experience: average R2

R-squaredUS: 1925.12-2000.12 (5-year non-overlapping window)

0

0.1

0.2

0.3

0.4

0.5

0.6

1926-1930

1936-1940

1946-1950

1956-1960

1966-1970

1976-1980

1986-1990

1996-2000

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Yale School of Management

Experience in other countries: fraction of stocks moving in same direction

Maxf: International Markets

0.500.550.600.650.700.750.800.850.900.951.00

UNITED STATESSOUTH KOREAMEXICOPOLANDCOLOMBIA

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Yale School of Management

Relation between press freedom and market efficiency

Countries without free press

Countries in-between

Countries with free press

64. 1%

66. 8%

71. 0%

60%

65%

70%

75%

1 2 3

Press freedom rankings: 1972

Fraction of stocks comoving: 1996

12

Yale School of Management

In an informationally opaque market, how would firms behave?

•“Bad firms” have the most incentive to go p

ublic

•“Good firms” do not want to go public

•What will happen to the stock market in the

end?

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Yale School of Management

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Yale School of Management

Extra Example with Bad Law,Bad Regulations and No Free Press: China

Regulation Changes on Seasoned-Equity Offering

Dec. 1993: must have been profitable in recent 2 yearsSept. 1994: profitable in recent 3 years, avg. ROE must

be above 10%. The expected after-tax ROE must be higher than bank savings interest.

Jan. 1996: in each of recent 3 yrs, ROE > 10%March 1999: over recent 3 yrs, avg. ROE > 10%; for

each yr, ROE > 6%March 2001: avg. ROE > 6%.

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Yale School of Management

The Result: companies manipulate earnings to meet whatever requirements for ROE

Distributions of reported ROEs