From Rich to Poor: A Plan for Stabilizing Investment Markets in Developing Countries

-- by Michael J. Johnston and Peter Wilamoski for the Caux Round Table. Compliments of the Papousy Endowed Chair in Business Ethics at Southern New Hampshire University.

Text Box: OUTLINE??1.?Background information ??2.?A discussion of the "hot money" problem??3. An agenda for ?? investment reform??

Over the last century, the economic gap between the richest and poorest countries grew wider. After all the development and expansion of recent years, more of the world's population lives in the poorest countries.

These countries need an array of resources in order to bring standards of living closer to minimally acceptable levels, and to narrow the income gap between them and wealthier nations. One undeniably critical resource is capital: capital to create businesses and jobs, capital to build infrastructure, and capital to create savings mechanisms for the population.

But more capital, by itself, will not solve the problems poor countries face. To effect meaningful change, more capital must come from a new and different source. More and more, the world's policy makers are showing a preference for foreign equity portfolio investments over traditional direct foreign investment, bank lending, and supra national aid.

The advantages of foreign equity portfolio investments are many:

they promote risk-sharing;
they reduce moral hazard;
they improve investment allocation; and
they provide flexibility and cushion to other kinds of investment.

With the benefits of foreign portfolio investment, however, goes the disadvantage of stock market volatility, known informally as "fickle money" or "hot money," which during times of economic difficulties can worsen a downturn, as occurred in the Asian crisis of 1997-98. The collapse of a single company or bank triggers the collapse of many companies and destroys the economic prospects of an entire country. Worse, the problems of one country spread across an entire region, with devastating consequences.

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What can be done?

Developed countries have already taken some steps to limit this volatility, but much more clearly needs to be done. The motivation for reform should be obvious: stabilizing shaky investment markets abroad creates a healthier world in which to invest and profit. This paper proposes specific reforms to help stabilize foreign portfolio flows to developing nations.

The first reforms must be made by the emerging countries themselves, to create a climate of trust for future investment. They need to ensure better control of capital, greater transparency of financial information, stronger corporate governance and more stringent bankruptcy laws.
A few reforms regarding crisis management are for supra national agencies like the International Monetary Fund and World Bank.
But, in addition, significant reforms must be made by the countries providing the investment capital. Source countries need to address issues of liquidity, risk-weighting, improved understanding with individual investors and better communication with all parties.

If these improvements to the investment environment are made, foreign equity portfolio investments should significantly increase, along with greater assurance that host developing countries will not re-experience the crises of 1997-98. Larger and more stable flows to developing nations will result in faster economic growth in them. In turn, faster, consistent, more stable economic growth will reward the portfolio investors. Improving market stability is a win-win objective for all parties.

1. Background Information

The role of the "virtuous circle" of publicly held corporations in solid economic development is well known. But the "virtuous" part of the system often requires attention, particularly in developing nations. Responsible foreign portfolio investment can help develop healthy domestic economic growth by offering several critical items, the first of which is capital. In addition, foreign shareholders can exert healthy pressure for vital improvements such as better asset allocation, full disclosure by corporations, standardized accounting procedures, equal shareholder rights, and fair and open equity markets. Foreign investors can exert needed impetus in helping developing nations progress toward broad and healthy public markets.

The developing economies of the world are playing economic "catch-up." A few countries control most of the world's wealth. Between 1900 and 1999, the per capita GDP gap between rich and poor nations of the world widened.

Most of the world's population live in developing nations, so the value to humanity of rapid economic growth in poor countries is enormous. Of the five most populous countries in the world, only one, the United States, is a developed country.

In political/economic terms, several significant developments are occurring simultaneously in most developing nations to spur economic growth. Almost all require outside capital. In addition, most such countries need political reform in order to attract capital, e.g. banking reform, privatizations, market regulation reform and others.

The means, scope and pace of change vary widely by country. Because of the great variations from country to country, it is somewhat unfair to generalize. Nonetheless, the practices that need to be improved in order to optimize access to outside capital differ only in the degree of improvement needed in each country.

Types of capital flows

Since this paper deals with the topic of foreign portfolio investment, the other types of significant outside capital should be identified, defined and differentiated from portfolio investment. Normally the largest and most consistent flow of outside capital is foreign direct investment. This capital derives from the direct investment of non-domestic companies, i.e. foreign corporations investing in plant and equipment in the host country, or buying real assets such as a domestic company. Besides capital, direct investment often brings important non-capital resources, such as technology and training.

A second large source of foreign capital is bank loans. Although significant, the flows can be quite volatile. A big problem with bank loans occurs when the loans are short term loans, i.e. one or two years, but the capital is invested "long," i.e. not available to repay the loan if the loan is not rolled over. This situation occurred in several countries during the Asian contagion and was one of the factors which deepened the problems.

A last major source of foreign capital is from other governments or from supranational entities such as the World Bank. These sources are quite valuable but have by necessity and intent begun to be a smaller proportion of total foreign capital. The supranational and public lenders increasingly see their roles as a lender to the poorest countries for truly basic needs, and even then as a lender of last resort. As a result, the World Bank has been one of the entities encouraging foreign portfolio investments.

(See Tables 1, 2 and 3)

The who's and what's of foreign investment

In order to understand more fully the role which foreign portfolio investment plays in providing capital to host countries, one needs to examine more closely the who's and what's of the foreign investor. What follows is an examination of that investor, and a description of the best conditions for attracting that investor.

The typical investor in emerging markets is an institutional investor. An institutional investor usually has a large pool of assets, hundreds of millions to tens of billions of dollars. The assets' beneficial owners might be pension funds in the source countries or other large, sophisticated owners of financial assets. Or in a minority of instances the beneficial owners might be individuals who own shares in a mutual fund.

Almost always there is a party responsible for managing the pool of assets for the beneficial owners. This party makes the ultimate decision what securities the pool of assets, or fund, will own.

The aim of these funds is to achieve a positive total return. Usually the beneficial owners have some benchmark or expectation against which they compare the investment results. Sophisticated beneficial owners may rigorously compare actual results to an index of emerging market countries. Less sophisticated owners may simply want better returns than they can get in their home country's market. In either case, severely negative returns, especially over an extended period, would probably result in a withdrawal of assets from the manager.

Benchmarking itself has pitfalls. Because some managers have only to beat the benchmarks to be successful, during crisis, managers often sell to get ahead of benchmark results.

The manager of these funds is typically sophisticated as an investor, and willing to take somewhat greater risks as an investor than the manager would accept in developed markets, but in return expects a higher return.

The manager's investment style might be from the "top down," an approach by which the manager allocates or invests the fund's assets by investigating the prospects for a country's economy, currency and stock market.

If inflation is controllable, if the currency seems to be stable, if the economy and domestic profits are growing, and if the aggregate of stocks in the market are not too expensive, then the manager feels comfortable investing assets in that market compared to other emerging countries' stock markets on the same criteria.

At the opposite end of the style spectrum is the "bottom-up" manager. This manager investigates individual companies within a country's market. If the company is well managed, well financed and growing, and if the stock of the company isn't too expensive, then the manager feels comfortable owning that stock, comparing it to other stocks which the manager might own.

Most managers' styles fall somewhere between these two approaches, between paying close attention to both the country and its markets, and to individual securities within those countries and markets.

What foreign investors require to invest

Here are the set of circumstances that managers and beneficial owners feel are important.

First, the country itself must offer the promise of stable, free market growth. Ingredients of this are a stable " perhaps democratic but not necessarily " political system. The economy must have structural soundness, parts of which are: a responsible central bank, conscious of controlled monetary growth; an open and independent banking system; a fiscally sound government budget, one where both the process of taxing and spending is responsibly controlled, but also where government deficits are reasonable in trend and reasonable compared to other measures, such as GDP; and inflation rates that are moderate and stable.
The stock market must be open and fair. This means: a stock market that creates pressure for open and fair disclosure of company information; an honest system of corporate reporting and audit; enlightened corporate governance to include protection of minority shareholder rights; one and only one class of shareholders; a legal system for the redress of grievances or disputes; an environment in which courts support the regulations and laws governing securities; and obstacles to self-dealing by majority owners. For example, a recent survey by McKinsey and Co. of 200 institutional investors in the U.S., Europe, Asia and Latin America found that, on average, they are willing to pay a premium of more than 20% for shares of companies that demonstrate good corporate governance. Relatedly, 75% consider board practices at least as important as financial performance. Having domestic institutions that must mark their portfolios to market also helps insure better internal depth to markets.
Finally, having viable domestic debt markets is a valuable adjunct to healthy equity markets.

Few countries, even in the developed world, have achieved total success on all of these important conditions. But the degree to which a country's economy or market conditions fall short, is the degree to which investors will stay away, or the degree to which investors will sell at the first sign of trouble.

Foreign ownership

Foreign portfolio investment provides capital to host country domestic corporations, hence it can preserve and enhance domestic control of the underlying assets. In addition, because the investors are normally sophisticated, global investors, they bring pressure to the host country to reform or improve in ways that should make the country even more compatible to additional foreign portfolio investors. These same improvements should also enhance the market climate of disclosure and regulation for domestic investors. And fairly functioning public markets can and do provide useful mechanisms for capital allocation.

Because the issue of foreign capital flows is inextricably linked to issues of corporate ownership, a brief background for the role ownership can play in emerging countries is helpful.

Since the dawn of the Industrial age, nations have wrestled with the ownership issues of business and commerce. Typically, in a country's early stages of industrial development, business is conducted by individual or family owned enterprises, state owned entities, or foreign owned companies. As economic development progresses, public ownership of companies, i.e. corporations with publicly traded equity, becomes more common. In fact, the value of emerging countries' stock markets as a percent of the world's stock markets has been increasing steadily over the last fifteen years.

General speaking, the successful ownership systems in developed economies -- having companies owned by a broad segment of shareholders within the society, as well as from outside the country (hereinafter referred to as "public ownership") -- is now accepted as a useful role model for other less developed economies. Public share ownership offers many advantages, at least as practiced in most developed countries. In most cases it leads to more effective commercial enterprises and generational succession, in addition to the essential role of providing new equity capital.

Not only are publicly owned enterprises often very good at producing goods and services effectively, but their existence alone improves the investment environment for large segments of a society. And the investment gains to a broad segment of a country leads to increased savings, which can then lead to increased capital available for economic growth. Larger pools of equity capital will support increased levels of financing, multiplying the capital available for deployment in developing countries.

Realistically, the ownership of developing country companies will continue to be characterized by control groups, with domestic institutions constituting much of the remainder.

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