The Quality of Political Institutions and Financial Liberalization in Emerging Markets Campbell R. Harvey Duke University and NBER Duke University Department of Political Science September 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 …

12 …but driven by emerging markets

13 …not developed countries

14 What type of political risk matters the most?

15 What type of political risk matters the most?

16 What type of political risk matters the most?

17 What type of political risk matters the most?

18 What type of political risk matters the most?

19 What type of political risk matters the most?

20 What type of political risk matters the most?

21 What type of political risk matters the most?

22 What type of political risk matters the most?

23 What type of political risk matters the most?

24 What type of political risk matters the most?

25 What type of political risk matters the most?

26 What type of political risk matters the most?

27 What type of political risk matters the most? 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?

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 –

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

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36 Liberalization Equity markets: 3. “Capital flow break points” Analyzed in Bekaert, Harvey and Lumsdaine (JFE 2002, JIMF 2002).

37 “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 Returns Country Moving From 25th Percentile to Median Capital Flow Break Points Financial effects

43 Impact on Correlation Country Moving From 25th Percentile to Median Official Liberalizations Financial 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 Real economic growth

48 Panel Econometric Framework: where y i,t+k,k is real per capita GDP growth between t and t+k Q i,1980 is initial GDP, X i,t represents control variables Lib i,t is a Liberalization indicator variable Real economic growth

49 Approximately 1% per year over 5-year period 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 years 3.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 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. Endogeneity and growth opportunities

57 Heterogeneity and institutions Why do some countries react differently than others to equity market liberalization? 1.Does the degree of liberalization matter? Yes. 2.The relation between financial development and equity market liberalization 3.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

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: where Stdev i,t+k,k is the standard deviation of real per capita GDP or consumption growth between t+1 and t+k, X i,t represents control variables, Lib i,t is a Liberalization indicator variable Economic volatility

63 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? YES 2.Robust to dating of Liberalization? YES 3.Business cycle effect? NO 4.Do other simultaneous reforms explain the volatility effect? NO Economic volatility

65 4. Simultaneous reforms: Institutions Economic volatility

66 Heterogeneity and institutions Why does consumption volatility react differently across different countries? 1.Financial development 2.Legal infrastructure 3.Political Environment 4.Investment conditions / protection

67 1.Financial development Heterogeneity and institutions

68 2. Legal infrastructure Heterogeneity and institutions

69 3. Political environment Heterogeneity and institutions

70 4. Economic conditions / investor protection Heterogeneity and institutions

71 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 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