Finance - Definition of Emerging Markets

Week 1 – Emerging Markets

Definition of Emerging Markets

• Financial markets of economies that are in the growth stage of their development cycle

• Also have low to middle incomes per capita

• IFC definition: market in transition with increasing size, activity and level of sophistication
• Textbook definition: Characterized as high rates of potential economic growth that are unrealized by underdeveloped capital markets

• “underfunded growth opportunities with problems”

• Desirable developments

• FELT – Fair, Efficient, Liquid, Transparent

Fundamental risk factors of emerging markets

1. Market capacity restraints – The scope and breadth of the equity, debt and capital markets and the overall trading activity
2. Operational inefficiency – Capital formation impeded by mechanical and technological inefficiencies in the trading systems
3. Foreign accessibility restrictions – Drawing on external sources of capital but there can be penalizing restrictions imposed on foreign investors and barriers to free flow of capital
4. Corporate opacity – A well-functioning market is more transparent with fair access to information to investors and mandates disclosure requirements and voluntary reports
5. Limits to legal protections – There should be strong and impartial legal systems to protect investors shareholder and creditor rights
6. Political instability – tougher political constraints limit autocracy and improve civil freedoms and limitations on corruption

Quantify risk factors through statistical analysis via Principal Component Analysis (PCA)

• Radar chart (a.k.a. Cobweb/Spider diagram)
• Median scores from -1 to 1, the lower the riskier/inefficient

Reasons to invest in EMs

1. Growth and Diversification – EM experience higher median GDP growth rates than developed markets
2. No need to ‘re-invent the wheel’ – Nothing new to the game (E.g. China, India, Thailand etc.)
3. Technology/Manufacturing – constantly in demand
4. Need for Infrastructure – physical and institutional

Investment opportunities

• Portfolio investment/private equity/venture capital
• Direct establishment
• Buyout local firms
• Mergers and acquisitions

Frontier markets in Asia

• Frontier markets are less developed than emerging markets
• Earlier stage of development and thus less regulated
• Increase in income per capita – disproportionately large return for investors
• Less correlated with developed markets – justifiable portfolio diversification

Examples of Emerging Markets

• China, India, Indonesia, South Korea, Malaysia, Philippines, Taiwan, Thailand

Examples of Frontier Markets

• Vietnam, Cambodia, Laos, Myanmar

Different classification of countries and markets

• FSTE International
• MSCI Emerging Markets Index
• Dow Jones Emerging Markets Index

Risks – taking risks in the best way investors can make profits and this occurs with volatility of the market (a characteristic in all markets, even developed ones)

Primary method of reducing risk

• Diversification of investment portfolio
• Aim for low/negative correlations between investments
• Expand basket of choices
  

• Sovereign risk?

• Most risky emerging markets are frontier markets
• Conventional wisdom: more risk more return

Week 2 – Governance

Definitions of Corporate Governance

• How companies behave in aspects of performance, efficiency, growth, financial structure and treatment of shareholders and stakeholders
• Narrow definition – CG deals with the way suppliers of finance to corporations assure themselves of getting a return on their investment
• Broader definition – CG is the system by which corporations are directed and controlled

• Objective of good CG is maximising contributions of firms to society

Two main aspects that countries can determine how effective the corporate governance is:

• Macroeconomic and financial indicators

• GDP per capita
• GDP growth
• Market capitalization
• Stock traded as % of MC

• Governance indicators

• Legal and judicial system
• Creditors and minority shareholder’s rights
• Efficiency of enforcement
• Anti-corruption
• Disclosure requirements
• Corporate governance opacity

Diversity of ownership structure

• The main issue of ownership structures is the PRINCIPAL-AGENT problem (agency dilemma/agency problem)

• When one person (agent) makes decisions on behalf of another person (principal)

• Agent – corporate managers
• Principal – shareholders

• Agents are motivated to act in their own interests, not their principals
• This is a circumstance of moral hazard

• Moral hazard is when a person takes on more risk knowing they are insured

• Ownership of shares – cash-flow rights
• Management of company – voting rights/control rights

Forms of ownership structure

• Family-owned/financial institutions controlled at the aggregate level (widely diffused/concentrated)

Diversity in group affiliation and institutional investors

• Bank or financial institution at the apex of the group
• Benefits: insurance effect, access to finance
• Costs: lack of transparency, distorting pricing and valuation, less than optimal operating performance
• This affects the way institutional investors behave in emerging markets

• They become the minority and have little direct influence
• More concerned about protecting themselves rather than focus on disciplining management

Channels which corporate governance can affect

• Increased access to financing

• Judicial system
• Property rights
• Link between financial developments and legal institutions

• Cost of capital is reduced when there is good governance

• Higher firm valuation and better operational performance

• Lower cost of capital results in higher asset price

This is because good governance brings about better performance (long term)

• Optimal allocation of capital
• Optimal deployment of labour

• Reward for merit rather than relations

• Promoting healthy competition where merit is key reward
• Better functional financial markets

• Better cross-border foreign investments
• Australia stocks are preferred

• Less volatility in stock prices
• Where to ‘park’ your money/capital because it’s safe and trustworthy

• Not doing it for the sake of returns nor interested in yield

Corporate governance Reforms

• Reforms of governance are needed whenever there are incidents

• Big corporate scandals (WorldCom, Enron, HIH)
• Financial crises (AFC, GFC)

• Entrenched owners/managers/politicians at a country level prevent or resist reforms as it may affect their power

• Political factors – Socialist democracy
• “The people are the master, but the Party leads the master”
• Political insiders receive benefits (monetary) and are unlikely to relinquish

• Typically indicate high levels of corruption in the political connections

• Cronyism – drives borrowing and lending at higher costs (family connected wealth threatened by reform)

• Defined as “appointment of friends/associates to positions of authority without proper regard to their qualifications”

• Recent legal reform in Korea after 1997 Financial Crisis

• Demanded mandatory quota for outsiders/independent directors in Board of Directors
• Resulted in improvements on valuation and operating performance

• Culture factors

• Autocratic society rooted in religion/culture/social customs/class/hierarchy
• Tend to hinder corporate governance and development
• Egalitarianism – everyone should be equal

Week 3 – Corporate Governance & Liberalization

Models of corporate governance