Spring Forum 2006 Spring Forum 2006
Spring Forum 2006

2006 SPRING FORUM

Kaufmann of World Bank Institute Delivers Keynote at EMTA Spring Forum
On April 20, 2006, at the midtown New York offices of Bear Stearns, Daniel Kaufmann, director of Global Programs at the World Bank Institute, addressed EMTA’s Spring Forum attendees on “The Link Between Good Governance and Economic Growth in the Emerging Markets.”

Kaufmann opened his presentation by outlining some common assumptions about governance that he intended to challenge: that it’s impossible to measure and/or analyze; that it’s important but has improved vastly over the years; that good governance and control of corruption are luxuries that a country can enjoy only once it achieves a certain level of wealth; that less developed countries are, by definition, poor and corrupt; that public-sector bureaucrats are always the source of corruption; that the corporate sector is a passive entity being acted upon by state policies; and that country-wide governance is not linked to financial market prospects at all.

“It’s imperative nowadays,” asserted Kaufmann, “to move well beyond the so-called Washington consensus” of a decade ago, in which the US Treasury, the IMF and the World Bank agreed on the main macroeconomic reforms that were required in Emerging Markets.  “Macroliberalization and privatization were the main mantras, which in my belief still apply,” he stated.  But because there was no focus on governance and corruption, many countries that did implement the Washington consensus have lagged behind.

Kaufmann’s analytical framework holds that governance is a set of traditional institutions by which authority in a country is exercised.  The three main components of the set can each be broken down into two measurable indicators: the political component, consisting of democratic accountability and the absence of violence and terrorism (which leads to overall political stability); the economic component, comprising effective government policies plus the quality of the regulatory framework; and institutional respect, measured by the rule of law in everyday life and control of corruption.

The speaker emphasized that this framework gives perspective to the issue of corruption control as only one dimension out of six, which is important because, Kaufmann suggested, “one doesn’t fight corruption by fighting corruption.  Corruption is mostly a symptom; an outcome of institutional failings in other areas,” such as freedom of the press, the civil service, overregulation, or rule of law.

Gathering and Analyzing Empirical Data on Governance
Kaufmann informed the audience that the World Bank Institute team collects data from 37 different sources from all over the world.  An advanced statistical method called an observed component model aggregates all the sources in the most efficient way to minimize margins of error.  The method itself gives different weight to different data sources, so that the more reliable sources with a higher signal-to-noise rate get greater weight.  “This method allows the data to speak,” observed Kaufmann.  “We as analysts make no discretionary decisions whatsoever; there is no US-centric or Eurocentric bias,” he noted.

With allowance for reasonable margins of error, the countries of the world resolve themselves into five main statistical groupings.  Kaufmann drew his audience’s attention to a world map showing levels of corruption control.  “What immediately jumps at the eye is another debunking of myth: the tendency we have to generalize, saying the less-developed countries are all corrupt, and the rich world is the least corrupt,” he stressed.  Kaufmann then pointed out that countries such as Botswana and Chile are actually less corrupt than some European countries.  “Obviously, on average, the richer countries have better control of corruption, but it’s very important to get to the specifics and not to generalize,” he emphasized.

Next, Kaufmann took on the assumption that governance has improved over recent years, along with macroeconomic indicators such as inflation rates.  His data on governance showed overall stagnation, or in some cases, worse governance than in prior periods.  “For example, in terms of rule of law, many countries in Latin American have not just stagnated, they have deteriorated, and they are lower than the average for Emerging Markets.  So obviously there’s an enormous challenge in this,” he commented.  Kaufmann believes that lack of progress in governance “has become an increasingly binding constraint on unleashing the potential for development in some countries.”

“The good news,” continued the speaker, “is that these averages are the outcome of enormous variance; even in a short period of time—6 to 8 years—we see in the data a group of countries that have significantly improved in governance.” There are about 25 countries worldwide, including Croatia, Mozambique and Colombia, which have improved during this period.  “The traditional view is that it takes generations for institutions to improve.  Of course, one doesn’t go overnight from the institutions of Gabon to those of Norway, but meaningful improvement can take place in 6 to 8 years,” he noted.

Does Good Governance Matter?
Kaufmann then addressed the relationship between good governance and prospects for growth.  His data and that of other analysts have led to a significant finding called “the 300% development dividend of good governance.” Essentially, an improvement in governance—rule of law, or control of corruption—will raise a nation’s per capita income by almost 300% in the long run.  Further, the amount of improvement needed to yield that result is not unrealistically large—just one standard deviation, which is one-fifth of the difference between the worst in the world and the best.

Kaufmann stressed that good governance leads to higher income, and not the reverse.  “We find no evidence for the politically correct notion that if only emerging economies magically got more income—from higher prices of oil, or just more aid—that in itself would automatically lead to improvement in governance, to control of corruption,” he declared, adding that improving governance requires sustained effort and political will.

Statistical analysis shows that the correlation between control of corruption and a country’s competitiveness in the world marketplace is .90.  “When a country improves governance and begins to control corruption, the competitiveness of the country increases by an average of 30 rung positions,” noted Kaufmann.

Governance and Investment
To see how much governance matters directly to investment firms, his team looks at data from enterprise surveys.  When asked “from your perspective, what are the most important obstacles to operations and growth?” official corruption and bureaucratic red tape were among the top answers for most countries.  In Latin America, for example, both infrastructure and tax regulation are areas of concern, but far less than corruption.

“It’s very important, when analyzing or advising a country, to unbundle these concepts of governance and corruption, and the new methods of measurement allow us to do that,” stated Kaufmann.  Again taking Latin America as an example, the primary business concerns of some years ago—petty bribery, getting a license or export permits or connections to utilities—have been replaced by procurement corruption and judicial corruption.

“State capture,” in which extremely powerful and wealthy firms basically purchase the policies and laws of the state, is a huge issue in other areas—the former Soviet Union being the prime example.  “Let’s not mince words,” proclaimed Kaufmann.  “We find through this data that some multinationals are not behaving in a manner consistent with improving governance in emerging economies….  A significant minority are not abiding by the recent OECD anti-bribery convention.”

The link between control of corruption and financial market volatility is particularly strong in Emerging Market nations.  Not surprisingly, where there is poor control of corruption there is more insider trading, and thus more volatility in the stock market.  Another explanation for market volatility may be herding, in which corruption and lack of transparency lead investors to mimic each other’s behavior without regard to rational expectations or hard information.  This leads to wider swings one way or the other.

Reviewing the literature on the links between governance issues and Emerging Markets, Kaufmann said that in misgoverned, opaque countries there’s not only a decrease in foreign direct investment, but the whole composition of investment changes—it’s much more skewed to short-term and volatile capital because there’s less willingness to commit for the long term.  “A financial crisis when an emerging economy is liberalizing its financial market is much less likely the more transparency and better governance there is,” noted the speaker.  The rule of law in property rights institutions matter not only for investment growth but also for financial market development.  Listening to domestic investors is the best predictor fur upcoming financial crises, he believes.  In countries where there’s a high percentage of misgovernance and corruption, the firms themselves say there is much greater fragility in the banking system.

There is also evidence that not only is focusing on capital market development important in understanding the governance situation in a country, but the relationship also works the other way around.  Making a conscious effort to increase foreign investment can have a healthy, disciplining effect on a nation’s governance as firms that are being approached for capital support often demand transparency.

In his concluding remarks, Kaufmann emphasized that governance issues can have a short-term effect on market volatility, but the more important impact is on sustained growth over a 5 to 10 year period.

Investor Panel Discusses “Abundance” in Emerging Markets
Kaufmann’s presentation was followed by a panel discussion moderated by Carl Ross of Bear Stearns.  In his opening remarks he recalled that at the time of the last Spring Forum a year earlier, the market was in the midst of a sell-off and most of the panelists were quite bearish.  A couple of the panelists thought the returns for the remainder of 2005 (April – December) would be in the 0–2% range, well below actual returns.  “It’s all good, yet we continue to have a pervasive feeling of uneasiness – but everybody seems to have trouble figuring out where the risks are and what the vulnerabilities are,” said Ross

Gray Newman of Morgan Stanley was invited by Ross to speak about the current atmosphere for Latin America.  “We are still in the midst of abundance,” he proclaimed, with abundance defined as liquidity, risk appetite, and the relationship between them.  “The way I look at it is abundance is permitting the region to move in two different directions.  Inflation is coming down, yields are compressing, fiscal prudence has improved, currencies are strengthening, rates are falling, and spreads are as tight as ever at the end of the Fed tightening cycle,” he stated.  The negative side is that Venezuela is ever-closer to a direct conflict with the U.S., poverty remains high, education levels trail East Asia, and equality remains a major issue, Newman noted.

Newman declared himself “positive in the near term,” chiefly because of Brazil, which has doubled reserves in the last 12 months, eliminated dollar-linked debt, brought net public external debt to near zero, and attempted to bring foreigners into local markets.  “I hear people say it’s all about flows coming into Emerging Markets, and I think that misses the point of what some of these countries are doing with the flows—improving duration, reducing their vulnerability to dollar obligations.  But when I look 3 or 4 years farther down the road, I run into the example of Mexico,” he commented, describing it as an investment-grade country which did what the market prompted it to do, and yet “half the country is still living at poverty level.” Newman pointed out that abundance has been good for rates and for domestic credit.  “But abundance isn’t enough—and it leads to complacency,” he warned.  Mexico and Brazil have shown they are able to withstand negative shocks, but Newman concluded by expressing concerns that these countries will use their newfound abundance in a way that will help build conditions for sustainable growth.

Ross then requested Mike Gagliardi of HSBC Halbis to address the importance of politics and election cycles in Emerging Markets, especially Latin America.  Gagliardi replied that there’s always a great deal of volatility, even mayhem, surrounding presidential elections there.  In some of the smaller countries, such as Ecuador and Bolivia, electoral “craziness” is irrelevant to trading, according to Gagliardi.  But in the larger countries, election upheavals have a lot more impact; the political process creates economic shock.

Turning to Gray Newman’s thoughts on abundance, Gagliardi noted that not only is abundance not enough, it also runs out.  “It’s been relatively easy to do the right thing, but we’re not pricing in the obvious signals that it’s not trickling down to the lower classes.” He cautioned that it’s only a matter of time before this abundance of liquidity starts to wane, and stated that he’ll be “less sanguine” about the politics when that happens.

Ross asked Gagliardi and Newman to name the countries they considered most vulnerable due to complacency, or abundance masking underlying fundamentals.  Both considered Argentina and Venezuela as the obvious candidates, despite “aggressive” pricing of their debt by the market.

The Role of Exotic Credits in EM Portfolios Discussed
Tackling the subject of less-mainstream credits, Mike Conelius (T. Rowe Price) remarked that one reason exotics are a good investment for smaller firms like his is that large firms are prevented from investing there due to capacity constraints.  “Another reason is this market is expensive, even more than last year.  The repricing of the majors is largely over, so if you want to add value and reduce risk in a portfolio, you need to move to some of the second-tier names,” he commented.  Conelius described his strategy as taking significant positions in smaller countries while generally ignoring the benchmark; he specified that basing a portfolio on current industry benchmarks is not a particularly successful strategy and called for broader indices that would combine local and hard currency debt.  According to Conelius, about 45% of his investments are in non-benchmark securities, and he noted he had invested in Jamaica, Iraq and Serbia.  Conelius cautioned however, that such investments must be based on fundamentals because liquidity can be an issue in smaller credits.

Ross asked Gagliardi, “our mentor and our sage in these matters,” for his views on current market trends.  Gagliardi joined Conelius in stressing the value of unusual opportunities such as off-the run credits, and mentioned Paraguay and Iceland as countries he had recently bought for the first time.  Gagliardi also expects the CDS market to continue to grow, he stated.

In searching for alpha, “we have to continue to look in every nook and cranny for opportunity, because buying a Brazil 40 or any of the other generic things—a lot of that’s done,” Gagliardi noted.  He stressed that investors must look at every asset class, country, region, as well as at derivative instruments.

Risk Factors
David Spegel of ING Financial Markets was invited to discuss key risk factors in the marketplace.  Spegel stressed that it’s important to distinguish between short- and long-term market risks.  “In the short term, the substantial rise in US Treasury yields—the 10-year yield has risen 45 basis points in a month and a half—is a risk that hasn’t yet been priced in,” he suggested.  The likelihood of a Fed fund rate rise to 5¼ by next September, the steepening of the Treasury curve, and the heavy election schedules in Latin America also constitute short-term risks.

“Contagion effects are a more serious risk for me, and more medium-term,” Spegel continued.  “There are far more corporates than there ever were, and credit risks there are not as heavily monitored as they are for sovereigns—which is one reason why corporate spreads continue to trade wider than sovereigns on a ratings-by-ratings basis.” In terms of dealer risk limits, there is not much capacity to absorb the amount of corporate paper that could be unloaded on the market, which may result in some contagion risk, Spegel commented.

As for long-term risks, Spegel first observed that credit risks are improving for Emerging Markets while deteriorating for the core high-yield markets.  There are two long-term risk factors that do worry Spegel.  The first is a rise in protectionism, although “the fact that we have elections coming up in November may be the reason we’re hearing more protectionist rhetoric in the US; I’m not sure we’re really going to make good on the most serious threats.” For Spegel, the most serious risk to global growth is oil prices.  At the moment, high prices reflect growth, particularly in Asia, rather than supply risks as they have in the past; incremental oil demand from Asian credits and average annual oil prices are almost perfectly correlated.  “I would look at any threat of action against Iran, or greater production cuts in Nigeria, as a threat to global growth and to commodity prices, which would be unfavorable for EM credit, as well as for FDI movement into EM.  Spegel concluded that “a rise in oil prices toward $100 per barrel, which would affect global growth and the potential for US interest rates to spike even higher than 5.5%, would pressure our asset class overall.”

The investor panelists were asked if, in light of all these risks, they were seeing anything suggesting reduced inflows into EM debt.  Conelius noted that there had been some periods of outflows in his retail fund, but that on the institutional side “I am tired of writing RFPs!” Pensions, with a 10-15 year time horizon, see small declines in the markets as buying opportunities.

Gagliardi concurred, stating “The face of the world has changed since these guys started getting involved.” He then joked that when the large pension funds put a small part of their portfolios into EM debt, “we’re almost irrelevant.”

Mixed Opinions on 2006 Returns
Ross asked for panelist picks over the next year.  Newman opined that Brazilian interest rates could decline to 14% in 2006, and even lower by the Spring Forum in 2007.  “That provides opportunities beyond the curve, in domestic names, equity markets, mortgages, accounts receivables, etc.” he advised.

Conelius predicted the EMBI+ could be at 180, assuming Fed funds at 5%, oil at between $60-70 per barrel and Lula is re-elected.  Recent sell-offs in assets such as NTNs and Iceland might present current opportunities; on the other hand Conelius didn’t think owning Venezuelan debt would pay off in the next year.  Spegel forecast that the EMBI+ would be at 190, supported by “the wall of institutional investor money that’s fueled by the ongoing recycling of petrodollars and high savings in Asia, as well as the pension reforms seen across the board.” Peru looked cheap to Spegel, “particularly in the 5-year portion of the curve,” as does Philippine paper of the same maturity.  Spegel also likes the Brazilian real, while acknowledging the potential election-related risks.

“Little to no change in the spread on the EMBI,” Gagliardi predicted.  However investors will still get double-digit returns on their portfolios by looking at local markets as well as EM equities and FX.

Ross offered his own forecast of an EMBI+ at 200 at year-end.  “The possibility of a 5.50% or even a 6% ten-year implies a pretty flat return between now and year-end, at least in the dollar debt,” he commented.

Emerging Markets in 2011?
To conclude, Carl Ross asked the panelists to make a prediction or two about how the Emerging Markets will look five years from now.  Spegel speculated that global imbalances will persist, Asian surpluses will decline, savings will rise and there will have been some currency adjustments.  In addition, he offered his assessment that “the IMF as we know it will not be around; it will have been restructured into something more of a research shop.”

Gagliardi had an even broader take on the question: “There’ll be just two ‘gunslingers’ left in the world, us and China….There’ll be such a fight over the resources we both need, I hope it doesn’t turn into anything more than just an economic struggle,” he cautioned.  He also admitted to pure hopefulness that sub-Saharan Africa will catch up with other emerging economies

Conelius predicted that over the next 5 years, Chavez will continue to be a problem, “though hopefully just for Venezuela” as the country’s luck will run out even if oil pricing remains at high levels.  Equity, as opposed to fixed income, will become even more important to smaller managers than it is now, as the large managers become overburdened with capacity, which will impinge on their performance.

Finally, tongue planted firmly in cheek, Gray Newman prophesied that “as the inevitable convergence of the two economies continues,” today’s discussion of Mexicans immigrating to the U.S. will be replaced by discussion of “baby boomers moving to retirement villas and health care facilities in Mexico, where the climate is better, costs are lower, and service is still possible.”