2. MARKETS AND INSTITUTIONS IN MIDDLE INCOME COUNTRIES: FOREIGN INVESTORS IN EMERGING DEMOCRACIES Javier Santiso Chief Economist & Deputy Director OECD Development Centre Casa de América Madrid, 8-9 June 2006

3. Foreign Investors and Emerging Democracies Introduction: A Research Agenda 1. Are Foreign Direct Investors Politically Correct? 2. Financial Markets and Emerging Democracies. 3. A Case Study: Wall Street and Brazilian Elections.

4. Introduction: A Research Agenda A Research Agenda: Foreign Investors and Emerging Democracies: The Political Economy of Capital Flows in Developing Countries (book project, 2005-2007). Capital Flows and Political Regimes: From Montaignes Doux Commerce to Hirschmans Passions and Interests. Financial Markets and Politics: Wall Street and Elections in Emerging Democracies - based on, Juan Martinez and Javier Santiso, «Financial Markets and Politics: The Confidence Game in Latin American Emerging Democracies», International Political Science Review, Vol. 24, n°3, July 2003, pp. 363-395; Financial Markets and Politics: Javier Santiso, The Political Economy of Emerging Markets: Actors, Institutions and Financial Crises in Latin America, New York and London, Palgrave, 2003.

5. Two Global Trends: A Democratic Wave …

6. … That has also been a Latin American Wave

7. A Second Global Trend During the 90´s: A boom of capital flows to emerging markets 7778798081828384858687888990919293949596979899012E -50 0 50 100 150 200 250 300 Latin America East Europe and Middle East Asia Total emerging markets Source: IIF, IMF, 2002. FDI total flows grew tenfold and commercial flows grew twice as much.

8. Latin America also profited from this boom of capital inflow... Net private capital flows towards emerging markets (billions of US $) -100 -50 0 50 100 150 70727476788082848688909294969802E -60 -10 40 90 140 Net official flowss Other investments (bank flows, etc.) Net portfolio flows FDI flows Flujos de capitales totales, netos Source: IIF, IMF, 2002.

9. -3 -2 0 1 2 3 4 5 6 -50-40-30-20-100102030 Change in capital flows (mM$) GDP growth (%) 99 00 01 02 … which is correlated to growth Period 1980-2002 Source: BBVA based on IMF database

10. 1. Are Foreign Direct Investors Politically Correct?

11. Low Confidence High Confidence China United States Mexico Poland Germany India United Kingdom Russia Brazil Spain France Italy Czech Republic Canada Japan Thailand Hungary South Korea Australia Taiwan Vietnam Hong Kong Malaysia Turkey Indonesia 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 (1) (2) (9) (11) (4) (15) (3) (17) (13) (7) (5) (6) (14) (8) (12) (20) (16) (21) (10) (24) (33) (18) (42) (29) (31) ( )= 2002 Values Calculated on a 0 to 3 Scale Source: A.T. Kearney, 2003 FDI Confidence Index 2003, top 25 Foreign Direct Investors Perceptions: Most attractive FDI destinations 2003

12. Least Attractive Global Investors Highly Attractive Jan 2000 Feb 2001 Sept 2002 Dec 1998 June 1999 FDI Index Score Source: A.T. Kearney Sept 2003 Latin America falls behind Asia Asia surpasses Europe Asia has overtaken both Latin America and Europe as a regional FDI destination

13. Source: A.T. Kearney, UNCTAD The Emerging Giants receive a large share of FDI flowing to the developing world 2002 Market Size Market Growth/Potential Production/Labor Costs Access to Export Markets Competitor Presence Availability of M&A Targets Financial/Economic Stability Political/Social Stability Tax Regime Infrastructure Transparency Highly Educated Workforce Quality of Life Thirteen attributes influencing FDI decisions were benchmarked across these markets The Emerging Giants – China, Brazil, Mexico, India, and Poland

14. Percentage likelihood of investing in China over these other markets (percentage difference in FDI Index scores) Source: A.T. Kearney Chinas lead over most emerging market destinations has strengthened

15. Relative attractiveness of various markets for selected aspects (weighted score of country rankings) China displays a comparative advantage in most FDI attractive aspects Source: A.T. Kearney

16. Comparative attractiveness of various markets for selected attributes (weighted score of country rankings) Comparative rates of stability among large emerging markets

17. Source: A.T. Kearney Percentage of global investors that ranked countries for High, Medium, and Low Risk China Brazil India MexicoPoland Relative risk profiles among large emerging markets

18. But, what about Democracy ? Democracy Index * 2002 0 0 6 6 7 8 8 8 9 10 02468 Cuba China Ecuador Venezuela Colombia Argentina Brazil Mexico Peru Costa Rica Bolivia Chile Uruguay US more democratic less democratic Source: Based on Jaggers, Keith y Monty G. Marshall. (2003). "Polity IV: Political Regime Characteristics and Transitions, 1800-2002". University of Maryland, 2003.

19. …and, Economic Freedom ? Index of Economic Freedom 1,80 2,35 2,50 2,65 2,80 2,95 3,00 3,45 3,50 3,55 4,45 0,001,002,003,004,005,00 US Spain Uruguay Bolivia Costa Rica México Peru Argentina Brazil Colombia Ecuador Venezuela China Cuba less libertymore liberty Source: Index of Economic Freedom 2003

20. And Property Rights ? Index of Property Rights Protection 1 2 3 3 3 3 3 3 4 5 5 012345 Cuba China Brazil Colombia México Panama Peru Venezuela Argentina Chile US More protection Less protection Source: La Porta, Rafael, Florencio Lopez-de-Silanes, Christian Pop-Eleches, Andrei Shleifer. (2003). Judicial Checks and Balances. NBER working paper 9775. Based on "Economic Freedom Index 1997".

21. 2. Wall Street and Emerging Democracies

22. Politics in Developing Countries Matter to Wall Street Investors

23. An Example: Calpers Screening of Developing Countries

24. Politics in Developing Countries Matter to Wall Street Analysts

25. But Are Financial Markets Politically Correct ? Interactions between politics and economics are also central to understanding financial crisis in emerging markets. Frieden, Ghezzi and Stein argued that weak governments might be more vulnerable to currency crises during election years. In a detailed study of the behaviour of real and nominal exchange rates in Latin America they confirmed that changes in exchange rate regimes coincided with elections. The three most recent and significant financial crises in the region -- Mexico in 1994, Brazil in 1999 and Argentina in 2001 -- took place during the corresponding presidential or parliamentary electoral year.

26. Financial Markets and Emerging Democracies

27. Historically, institutional instability and political uncertainty have favoured crisis 18251830183518401845185018551860186518701875188018851890189519001905191019151920192519301935 Argentina (28%) Bolivia (18%) Brazil (17%) Chile (24%) Colombia (49%) Costa Rica (30%) Ecuador (62%) Guatemala (48%) Honduras (79%) Mexico (57%) Nicaragua (45%) Paraguay (26%) Peru (39%) Salvador (29%) Santo Domingo (41%) Uruguay (12%) Venezuela (45%)

28. The Timing Game: Political Cycles and Crises in Latin America Nominal exchange rate depreciation and government change 0,94 0,96 0,98 1 1,02 1,04 1,06 1,08 1,1 1,12 1,14 1,16 -9-8-7-6-5-4-3-20123456789 Source: Frieden, Ghezzi y Stein, 2001 Country`s Total Elections 1Colombia13 198917 2Costa Rica11 199014 3Guatemala11 19913 4Ecuador10 19920 5Chile10 199310 6Peru10 199418 7Honduras10 19956 8Paraguay9 19968 9Brazil9 19977 10El Salvador9 199815 11Republica Dom.9 199912 Uruguay9 200011 13Mexico9 20014 14Argentina8 200213 15Nicaragua8 20038 16Panama8 20046 17Venezuela8 20055 18Bolivia7 200611

29. Mexico and the steady hand of the six-years period Monthly exchange rate variation (%) -20 0 20 40 60 80 100 ene-76ene-78ene-80ene-82ene-84ene-86ene-88ene-90ene-92ene-94ene-96ene-98ene-00ene-02 electoral year electoral year electoral year electoral year electoral year Source: Elaboración propia en base a FMI The Mexican peso behaviour before and after the elections (daily ppd; 90 days before and after) 9,0 9,2 9,4 9,6 9,8 10,0 10,2 7,7 7,8 7,9 8,0 8,1 8,2 8,3 8,4 8,5 Elections 1997 2000

30. A First Approach to Wall Street Political Preferences: The Index Game EMBILEMBI+EMBIEMBI GLOBALEUR Diversified GLOBAL Diversified Countries19313119 Includes defaulted?YesYesYesYes Includes Quasi Sovereigns?NoYesYesYes ICriteria for inclusionBBB+ orLow/MiddleLow / MiddleLow/Middle underincomeincomeincome Min. Issue Size$500m$500m$500m500m Liquidity CriteriaYesNoNoNo Face ConstraintsNoNoYesNo Market Cap$158bn$214bn$138bn 26bn Largest CountryMexicoMexicoMexicoTurkey Largest Weight22.4%20.7%12.2%10.3% Sharpe Ratio* 0.570.590.681.33** Historic data back toDec 93Dec93Dec93Dec98 More Diversification Less Liquidity Source: JPMorgan, Mar 31, 2002. * Sharpe ratios for Dec 90-Nov 02. Pre 1993, we link EMBI returns. ** EMBIGD Sharpe is Dec 98 - Nov 02. Investors are moving to EMBIGD for diversification

31. The Index Game: Market Capitalisation Source: JPMorgan, Mar 31, 2003. By Region By Rating (Av. = BB)By Country EMBIG $ (ext): $210bn EMBIG EUR (ext): EUR 36bn EM Corporates: $100bn Local Markets (Free):$900bn EM Total:$1,400bn Source JP Morgan, Mar 31, 2003 EMBI Global Diversified Weights GBI:$7,000bn US Aggregate:$7,000bn Global Aggregate:$14,000bn US HY: $700bn Source JP Morgan, Mar 31, 2003

32. The Political Economy of Indexes

33. 3. A Case Study: Wall Street and Brazilian Elections

34. Analysts Analyzed: Wall Street and the 2002 Brazilian Presidential Election.

35. Wall Street Shifting Involvements: The Lula Effect

36. Extreme Overreactions: Exit, Voice and Loyalty in Financial Markets

37. Brazilian Elections and Financial Markets: A Case Study in Historical Perspective.

38. In 2002 the opinion polls registered an evolution parallel to those experienced in 1994 and 1998 with a progressive decline of Lulas popularity from May-June.

39. On comparing the graphs corresponding to each of the three last electoral years, a certain seasonality can be observed with regard to the movement of the spread between Brazil and the group of emerging bonds.

40. However, the further deterioration of the Brazilian debt position in the May-July period is associated with other factors, such as the inherent dynamism of the Brazilian debt.

41. This valley of transition aspired to limit the impact of the elections on Brazilian debt.

42. Lula and Ciro Effect versus Cardoso Exit

43. In 2003: Wall Street Mea Culpa and Love Affair With Lula Best Performers in Equity Markets in 2003 BestYearly Performance (in %) * Argentina121 Thailand118 China117 India102 Brazil90 Worst Venezuela20 Finland21 Malaysia21 Netherlands24 Poland24 Source: Thomson Datastream Note *: In dollar terms.

44. Lula Light: Institutional Reforms and Confidence Building Brazil Reform Scorecard in April 2003 According to Merrill Lynch ReformChangeRecent DevelopmentsQuality Score (1)Progress ScoreReform Score Social SecurityNeutralPresentation 16-17 April2.5 5.0 Tax ReformNeutralPresentation 16-17 April2.5 5.0 Central Bank AutnonomyPositiveFinal vote expected by mid April4.01.55.5 Bankrupcy LawNeutralAlready in Congress3.0 6.0 Reform Agenda2.72.55.2 Compositve Score (2) Source: Merrill Lynch, April 2003. Notes: (1): The scorecard summarizes the Progress Score, which range a higher score in a scale from 0 to 5 to a reform the closer is to being approved, and the Quality Score, also evaluated on a scale from 0 to 5 and with higher points the closer the reform's current form is to a first best reform. (2) Reform Agenda Composite Score gives the weighted score of the reforms as per the following weights: social security 50%, tax 25%, bankrupcy 15%, and Central Bank Autonomy 10%.

45. Lula Light: Institutional Reforms and Confidence Building Brazil Reform Scorecard in December 2003 According to Merrill Lynch ReformChangeRecent DevelopmentsQuality ScoreProgress ScoreReform Score Social SecurityPositiveApproved by the Senate 2nd round3,558,5 Tax ReformPositiveApproved by the Sentate 1st round24,86,8 Central Bank AutnonomyNeutralComplementary Law expected in 20044.026 Bankrupcy LawNeutralApproved by Lower House (next Senate)3.047 Reform Agenda3,14,57,6 Compositve Score (2) Source: Merrill Lynch, December 2003. Notes: (1): The scorecard summarizes the Progress Score, which range a higher score in a scale from 0 to 5 to a reform the closer is to being approved, and the Quality Score, also evaluated on a scale from 0 to 5 and with higher points the closer the reform's current form is to a first best reform. (2) Reform Agenda Composite Score gives the weighted score of the reforms as per the following weights: social security 50%, tax 25%, bankrupcy 15%, and Central Bank Autonomy 10%.

46. Lulas Government Temporal Adjustment 2003 Timetable for Congressional Passage of Brazilian structural reforms Legislative PhasePensionTax Lower HouseJudicial CommitteeJune 5May 28 Ad-hoc committeeJuly 23August 26 1st Floor VoteAugust 5Septmeber 3 2d Floor VoteAugust 27September 24 SenateJudicial CommitteeOctober 5November 5 1st Floor VoteNovember 26December 11 2d Floor VoteDecember 16December 19 Source: JP Morgan, December 2003.

47. Debt Intolerance and Serial Defaulters

48. A Bias for Hope: The Exit From Institutional Traps is Possible

49. Conclusion: Enter The Matrix of The Political Economy Capital Flows The question of instability and uncertainty is central to understanding the intricate links between financial markets and politics in emerging economies. Where institutions are weak, and consequently the governments ability to honor its promises over time is questioned, the identity of the winning candidate becomes much more important to investors than in countries with strong and stable institutions. At a more fundamental level, examination of market reactions to 2002 presidential elections in Brazil encourages broader and systematic reflection on the relationship between democracy and financial markets. In the end, if we accept Przeworski's definition of democracy (i.e. a regime whose essence is the institutionalization of uncertainty locked in electoral outcomes), it opens the question of the political preferences of financial markets

50. In Search of a Better World: What About a Democratic Premium? In other terms, do financial markets give a positive premium to democracies or, on the contrary, democratic elections in emerging countries, because they bring uncertainty, are systematically correlated with financial volatility, rising risk premiums and exchange rate ups and downs? Regarding creditworthiness, a recent research underlined that there is a lack of democratic advantage. Even if democracies are supposed to pay lower interest rates than authoritarian regimes (because more capable of making credible commitments to repay their debts), the evidence shows that this expectation is unfounded. What about Basel II? Would it be possible to think about a democratic premium, to link capital flows with political development?

51. In Search of a Better World: Ethical Governance and Development Banks are increasingly paying more attention to ethical issues. In June 2003, nine banking operators, among the first 100 lenders, embraced standards that tried to avoid project finance that could contribute to pollute the environment, to erase forests and to destroy the livelihoods of local people. But what about the New Chinese Frontier? By the early 2000s CALPERS began to implement its policy in emerging equity markets, screening countries and stocks according to their ethical and financial standards. The move is an important step because it has been made by a major operator in financial markets that actively manages up to $1 billion of emerging market assets. But what about export credit agencies?

52. MARKETS AND INSTITUTIONS IN MIDDLE INCOME COUNTRIES: FOREIGN INVESTORS IN EMERGING DEMOCRACIES Javier Santiso Chief Economist & Deputy Director OECD Development Centre Casa de América Madrid, 8-9 June 2006