Emerging Market Strategies: Recent Comments

Comment on China Risks

William Gamble — Thu, 20 Sep 2007 14:16:16 GMT

Tristan Yates

Thank you for your comments to my blog.

While I generally agree with your premise regarding other emerging markets, I would make two caveats. First, emerging markets are highly volatile. So even if the markets fairly represent some increased level of economic growth and earnings of companies a world wide recession would have dramatic impacts on these markets. Even if they are not ‘bubbles’, they may act like them.

Second, in law and economics the probability of anyone obeying a law is a function of the severity of the punishment and the probability of getting caught. I also believe that in any country, if there are large economic incentives to lie and few legal disincentives to make people or companies tell the truth, people and companies will lie. As we saw in the dot.com boom and even today, often companies will use different means to manipulate their numbers. This happens in well regulated markets. I markets that have weak regulation, which is most of the emerging markets, the numbers are going to be off.

This is especially egregious in place like China and Russia where not only are the legal systems weak, but information is actively suppressed. Markets are about choice. To make an informed choice requires timely and accurate information. To get information requires that the press be protected. Regulators without conflicts also must enforce the rules.

I do not know how you do your analysis, but any fundamental or quantitative analysis must be based on facts. If the facts are questionable, so will the analysis. I am not sure that using methods that have been developed for markets with good legal systems are accurate for those without those systems.

William Gamble

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Comment on China Risks

William Gamble — Thu, 20 Sep 2007 14:13:47 GMT

Tristan

Thank you for your time.

You are helping me with my own debate.

Let me start with my premise. In law and economics whether someone obeys a law is dependent on a function of the probability of getting caught vs. the severity of the punishment. For example, if speeding was punishable by death, but the probability of getting caught was zip, then people would speed. If you had a 100% probability of getting caught for securities fraud, but the fine was $5, securities fraud would increase.

Let me look at your points. Starting with the easy ones.

1. Hong Kong, Singapore, Korea, and Taiwan. I totally agree with your points here, at least in regard to the past. I believe that Hong Kong and Singapore were both fortunate and wise. They were fortunate to have inherited a good, honest, efficient legal systems from the British and wise enough to keep it. I believe that Korea since the Asian crises has made the greatest strides in its legal system. My guess is that they realized they had to have a competitive advantage to attract investment from China and Japan. Dubai made a similar decision. I do not know enough about Taiwan. I certainly seems to have a better or as I say, a more economically efficient legal infrastructure than other ‘tigers’ like Thailand, Philippines and Indonesia.

2. Korean v. Chinese stocks. I am not convinced that development levels has much to do with risk, or specifically legal risk, which is different from economic risk (stock go up and down) or political risk (confiscation/regulatory change that benefits another constituency). Law can function in two ways. It can extend power or it can limit power. It is more economically efficient if it limits power by protecting property rights. If it is used to extend power property rights are threatened as is the open and transparent functioning of the market place. Korea as a democracy uses law to limit power. This is especially true over the past six years as her regulators have gotten more professional with some notable exceptions (Lonestar/KE. China on the other had is the reverse. It uses power to extend and maintain the rule of the Communist party. The party has to feed its members, many of whom at this point rentiers. Rentiers motivation is to raise the rent. They symptoms are the rising GINI coefficient along with corruption. The same thing is happening in Russia. The Moscow times estimates that the amount of bribes exceeds the tax receipts. My bet is that China is the same way. So for me the economic incentives would tend to lower risk, specifically legal risk in Korea and increase it in China.

3. Industry regulators. Industry regulators work only if they are true referees and not players. To have true referees they have to be free of conflicts of interests. Their economic incentives and legal disincentives must be free from the economic incentives of the markets they regulate. For example, central banks work better if they are independent. This is impossible in China where the regulator is a government agency and the all or almost all the companies listed on the market are government owned companies. There is no independent court system. So even if the regulator was independent, there is no way it can enforce its orders. It is like the in the US the Treasury department trying to regulate the Justice department. The profits from listed state owned companies accrue to whom? Communist party members. So there is a massive economic and political incentive to keep the party going. The incentives are to protect the party, not the people. This, of course, is not unique to China. It happens all the time in the US. The only difference is that occasionally the party changes. So the bottom line is that in some emerging markets, I would not trust the regulators at all. Even in developed markets there is a question. In the US the SEC has prosecuted tens if not hundreds of thousands of insider trading cases. In Japan the law has been in existence for less than five years and they have prosecuted 40.

4. Credit rating agencies: Some people in the US feel that the government was not honest with the country about the reasons for invading Iraq. In fact if you turn on any news program in the US there is a constant debate about who is telling the truth. Recently the financial press have been filled with questions about the objectivity of the rating agencies regarding sub prime products. From what I read, it seems that investment bankers worked closely with rating agencies and adjusted their products to get better a better rating. This occurred in a country where free speech I protected and there are a plethora of efficient and honest regulators. Besides, regulators can only deal with the numbers they have, If there is an economic incentive to lie, which in all markets is huge, and small legal disincentives, I believe that people will follow their own best interests. So in most emerging markets, I would be very uncomfortable trusting a credit rating agency.

5. Audit firms: This is the best argument. As you correctly point out, audit firms have legal disincentive outside of the country in which they do business. I am sure that they do their best to provide accurate information, but they still have to operate within the system. For example, after its IPO, China Construction Bank (CC reported higher earning because of a tax savings. Fine. The problem was that the tax law had been changed specifically for CCB to allow them to realize the tax savings. No audit can take place in a vacuum. There are rules and regulations that impact on every part of the auditing process. The problem is that western investors just assume that the audit will protect them. Even the auditors have to rely on the numbers that they are given. To take the Chinese state owned banks again, these banks have independent branches that really do function independently. What they send to the head office may or may not reflect reality. In addition my limited experience with American companies was that there were all sorts of accounting games being played between the subsidiaries and the headquarters. Bending the rules was part of the fun. In countries where the powerful make up the rules at will, it is best not to assume that the numbers actually mean something.

Stock certificates, annual reports, contracts, balance sheets, patents, regulations at the end of the day are only pieces of paper. Unless supported by a legal system they have no more worth than confetti. To assume that such a system exists in most of the world is to assume a huge risk. Remember markets are about choice. To make an informed choice requires accurate and timely information. Accurate and timely information requires protection of speech.

William Gamble

Comment on China Risks

Tristan Yates — Thu, 20 Sep 2007 13:51:14 GMT

Hi William. Thanks a lot for responding. I like your blog and appreciate your time.

Regarding the data, it's an easy criticism to make, but I don't think its correct. Most large companies in emerging markets are audited by PwC, Deloitte, KPMG, etc, and auditors can be liable for both civil and even criminal liability if they don't to their job well - consider PwCs botched audit of Gazprom in 2002 and subsequent lawsuit by Hermitage, a minority investor. The FBI was actually involved, as they can be called in to protect US shareholders. The companies are also monitored by the public credit ratings agencies (Fitch, Moodys,
etc) and by other industry regulators and are expected to adhere to International GAAP. And by the SEC too, if they have ADRs or are listed in NYC like Infosys or Wipro, or London like Gazprom.

I received my MBA at INSEAD and spent most of my time there at the Singapore campus, and we did a lot of analysis on companies in emerging markets using their public filings. The industry that was singled out by our star accounting professor (David Young) for the most fraud was actually technology and companies with high capital costs, like telecom.

Also, its hard to generalize about emerging markets. You could make a case that the four tigers, Korea, Taiwan, Singapore, and Hong Kong shouldn't even qualify as emerging markets anymore. The risk profile is totally different in those countries than for Russia, China, or India, so its easy to argue that the risk/reward tradeoff is much better for Korean stocks than Chinese stocks just based upon the relative development levels.

Thanks,
Tristan

Comment on China Risks

Tristan Yates — Thu, 13 Sep 2007 12:09:41 GMT

You'll likely be interested in our PlanetQuant article on SeekingAlpha where we track earnings growth, PE, and 1yr return. The data suggests that the emerging markets bubble is only contained in China. Other tracked markets in Asia still have reasonable valuations despite their high price increases.

http://seekingalpha.com/article/46933-planetquant-s-world-equity-rankings-and-etf-analysis