1. Yale School of Management 1 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?

2. Yale School of Management 2 Rule of Law and Capital Markets Country Groups based on the Rule of Law Index Best Middle Worst Best Middle Worst Bond Mkt Value/GNP Ratio (%) # of Public Companies per million of population

3. Yale School of Management 3 Press Freedom and Capital Markets Countries with the press not free Countries with free press Press freedom rankings: 1972 Capital market data: 1995 Sample: 60 countries

4. Yale School of Management 4 Why is it so hard? Trading apples and oranges vs. Trading stocks and bond

5. Yale School of Management 5 Degree of stock price comovements across countires: why?

6. Yale School of Management 6 % of stock returns explainable by market returns across countries: why?

7. Yale School of Management 7 Why such a big difference in stock comovement? Consider a simple model: two firms traded: A & B Both 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 higher?

8. Yale School of Management 8 The U.S. Experience: fraction of stocks moving in same direction

9. Yale School of Management 9 The U.S. Experience: average R2

10. Yale School of Management 10 Experience in other countries: fraction of stocks moving in same direction

11. Yale School of Management 11 Relation between press freedom and market efficiency Countries without free press Countries in-between Countries with free press Press freedom rankings: 1972 Fraction of stocks comoving: 1996

12. Yale School of Management 12 In an informationally opaque market, how would firms behave? “Bad firms” have the most incentive to go public “Good firms” do not want to go public What will happen to the stock market in the end?

13. Yale School of Management 13

14. Yale School of Management 14 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 years Sept. 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%.

15. Yale School of Management 15 The Result: companies manipulate earnings to meet whatever requirements for ROE Distributions of reported ROEs