ARE RETURNS OF EMERGING MARKETS’ INVESTABLE STOCKS SUBJECTED TO A CAPITAL CONTROL PREMIUM?

1. ARE RETURNS OF EMERGING MARKETS’ INVESTABLE STOCKS SUBJECTED TO A CAPITAL CONTROL PREMIUM? Eric Girard and Hamid Rahman

2. Introduction • Equity risk premiums are central components of every risk and return model in finance and are fundamental and critical components in portfolio management. • Return generating process of individual stock is difficult to evaluate in emerging markets, • Our paper attempts to identify risks affecting long-run stock returns in an asset block comprised of 29 emerging capital markets. • Many countries have embarked on a process of privatization and stock market liberalization with the goal of deepening their markets and improving corporate governance for a nascent private sector. • Do stock returns reflect the ongoing infrastructure improvement in the Emerging stock markets? What risks are involved when investing in these markets?

3. What we know • Chan, Hamao and Lakonishok (1991), Aggarwal, Hiraki, and Rao (1992), Fama and French (1992 and 1996) • Fama and French (1998), Patel (1998) and Rouwenhorst (1999) • Daniel and Titman, (1997), Claessens, Dasgupta, and Glen (1998), Harvey and Roper (1999), Lyn and Zychowicz (2004), Ramcharran (2004), Bolbol and Omran, (2005) and Girard and Omran (forthcoming) Return generating dynamics in the emerging markets above and beyond those found in the developed markets.

4. An additional Factor? • In many emerging markets, stocks listed on the market are not equally accessible to foreign and local investors. Standard & Poor’s/International Finance Corporation (SP/IFC) lists twenty-nine emerging markets in 2004 in which listed stocks are either partially or fully restricted for trading by foreign investors. • The practical implication of these restrictions is to split the stock market of these emerging economies into a segment in which foreign investors can trade stocks (investable) and a segment in which they cannot (non-investable). • Several papers have found that an increase in openness, i.e. making a larger share of the market open to foreign investment, is usually associated with small or large decrease in cost of capital (Bekaert and Harvey, 2000; Henry, 2000a and 2000b; Edison and Warnock, 2003; and Karolyi and Stulz, 2003). • This should theoretically imply that a portfolio of investable securities should bear a premium as compared to a portfolio of non-investable stocks, reflecting a compensation for segmentation and capital control. • So, one factor contributing to the specific dynamics of emerging markets is investment restrictions on foreigners in these markets.

5. What are we doing in this paper? • Our study measures this “investable” premium, • relates it to macroeconomic, financial and political influences, • and investigates whether the risk factors associated with this investable premium explain the cross-sections of 1312 emerging markets’ stock returns traded from 1989 to 2004. • No previous paper has specifically examined the relationship between investable risk and stock returns. Our paper, therefore, makes an original contribution in this area to the extant finance literature. In addition, it provides support for the findings of Claessens et al. (1998), Lyn and Zychowicz (2004), Ramcharran (2004) and Girard and Omran (forthcoming) that firm risk premiums are positively related to size, market-to-book value and beta.

6. Literature review • On the relationship between systematic risk and premia it is generally not clear how to measure risk. • When investing abroad: a world CAPM states entails strong assumptions of perfect market integration, it fails in emerging markets and is unreliable in smaller, less liquid developed markets. Erb, Harvey and Viskanta (1995): country beta less than one in most emerging markets and often inversely related to returns • Time varying world beta reflects how investors expect to be rewarded in connection with a change in risk in the world market (Bekaert and Harvey, 1995). However, less integrated markets are more likely to experience local market inefficiencies. Bekaert and Harvey (1995) suggest that the CAPM needs to be modified to account for partial or nascent financial integration. • An alternative? Erb, Harvey and Viskanta (1995) show that a country risk rating model has the advantage of including sovereign credit risk. Using political risk, economic risk, financial risk and composite ratings (ICRG), they conclude that ratings predict inflation and are correlated with wealth. They also observe that a lower rating (higher risk) is associated with higher expected returns. • Erb, Harvey and Viskanta (1996b) investigate how ICRG composite risk scores (political, financial and economic risk) explain the cross-sections of expected returns on IFC country indices. economic and financial risks are the most significant factors determining expected returns in developed markets, while political risk has some marginal explanatory power in emerging equity markets. • At the stock level, empirical research has shown that some fundamental firm-specific factors--size, leverage, book value to market value of equity-- are more suited to describe the cross-sections of US and Japanese stock returns (Chan, Hamao and Lakonishok, 1991; Aggarwal, Hiraki, and Rao, 1992; and Fama and French, 1992)—i.e,there is a premium for small and value stocks in foreign developed markets. In emerging markets, Claessens, Dasgupta and Glen (1998), Lyn and Zychowicz (2004), and Ramcharran (2004) describe results contrary to the conventional belief that small and value firms are riskier.

7. Evidence of the Investable Premium • The Standard and Poor’s/International Finance Corporation’s (SP/IFC) Emerging Markets DataBase (EMDB) of June 2004 reports twenty-nine stock markets with foreign investment restrictions. • Edison and Warnock (2003) show that these two indices can be used to measure the intensity of foreign ownership in a market. A “non-investable” index can be implied from IFCG and IFCI series as follows, • It follows that the investable premium is the difference between the investable and the non-investable return at any point in time.

9. Political, Economic and Financial Determinants of Investable Premiums • We relate investable premium to political, economic and financial risk factors. Erb, Harvey and Viskanta, (1995, 1996a, 1996b and 1998), conclude after an extensive survey that the country risk factors and scoring system used by the International Country Risk Guide (ICRG) managed by the PRS group best explains index returns. • ICRG assesses a country risk based on three dimensions – political, economic and financial. Each dimension is measured using several factors. The political risk dimension is measured using twelve factors and the economics and financial risk dimensions are measured using five factors each. • There are two conclusions that can be drawn from these observations: (i) risk score includes information that cannot be aggregated in a composite measure; and (ii) some risk factors have a greater bearing on business or investments than other. • For a composite risk rating to be useful for an analysis of the kind we contemplate, the factors should be differentially weighted to allow for greater weight to those factors that have a greater bearing for business. Since this is not the case with the ICRG composite risk rating, we prefer to use the twenty-two primary ICRG risk factors (twelve political, and five each economic and financial) in preference to the ICRG composite measure. Factors are determine with PCI. • We investigate the linear relationship between investable premium and the country risk factors. Investable premium is linearly related to these twenty-two risk factors plus its own idiosyncratic disturbance as follows:

10. Principal Component Analysis

11. Stepwise regression (HAC standard errors) Only factor (1) explains investable premiums. This factor has loadings of Government Stability, Investment Profile, Exchange rate stability, International Liquidity, Budget balance, Current account to GDP, Growth in real GDP, and Inflation. The sign associated with factor 1 is consistent with the theory—i.e., there is a negative relationship between investable premiums and factor 1. This result implies that the observed investable premiums across countries are justified by political, economic and financial risk components.

12. Cross-sections of returns and risk factors • We investigate whether country investable risk drives cross-sectional expected returns in investable emerging market stocks in addition to established firm specific risk components such as beta, size and price-to-book-value ratio (PTBV). • We retrieve 1784 investable firms traded in the 29 emerging markets from 1989:01 to 2004:06. Monthly return, size, and PTBV series are retrieved from EMDB for each firm. • Deletions: Stock return series must have at least 3 years of data (36 data points). Data imperfections like missing values and recording errors are handled by dropping the firm for the particular month of data imperfection but retaining it as part of the sample. The final sample consists of 1312 investable firms traded in 26 emerging markets. The sample period is broken down into two sub-periods, 1989:01 to 1997:04 (1144 firms) and 1997:05 to 2004:06 (1183 firms). This choice is made for two reasons: First, the period 1989:01 to 1997:04 matches the period covered by Rouwenhorst (1999) and thus permits an easy comparison of our findings with his and, second, it enables us to test the temporal stability of our findings. • In order to allow comparability, all returns and market capitalization series are converted into U.S. Dollars using the exchange rates provided by EMDB. The return series for each stock and each market (IFCG) are then transformed into risk premium series by subtracting the US monthly T-bill rate. 2 step evaluation of risks: • Each firm’s beta and investable risk is evaluated using a two-factor CAPM representation • Cross-sectional relationship in the twenty-six emerging capital markets between long-term risk premium and four risk measures (beta, investable risk, size and PTBV) using a multifactor extension to CAPM

13. Cross-sections of returns and risk factors • Positive risk premium for size in all markets– (+) in 14 markets, aggregate level and across periodssupport for Claessens et al. (1998) • PTBV and risk premiumsignificant in only 3 markets, not significant at aggregate levelsupport for Claessens et al. (1998) • Beta and risk premium,significant in 9 out of 16 markets, is inconsistent (-) in 6 and (+)in 3, (-) aggregate relationship across periods. • Significant investable risk in 15 out of the 16 markets. Relationship is overwhelmingly (+), consistent at the aggregate level and across perios it supports our research hypotheses that investable risk is priced. • Size and investable risk at the aggregate level are important to price emerging market firms.

14. Conclusion • We formalize the concept of investable premium using the IFCG and IFCI indices, and use data from the EMDB to validate the existence of investable premium in 29 emerging markets with foreign investment restrictions. • PCI is employed to whittle down from twenty-two political, economic and financial country risk factors, six factors that explain the investable premium. Stepwise regression then enables us to select just one factor that best explains the investable premium—a mix of political, economic and financial risk measures. • We investigate whether country investable risk drives cross-sectional expected returns in investable emerging markets’ stocks beyond established firm specific risk components such as beta, size and PTBV. A multifactor CAPM allows us to calculate the rewards that investors will want to receive in exchange for bearing the risks attached to a security. We document a significant positive investable premium for the aggregate sample. This finding supports our research hypotheses that investable risk is priced. We also find a significant positive relationship between risk premium and size at the aggregate level. Our findings suggest that these two risk metrics are important to price emerging market firms. • Political risk is likely to remain significant in emerging markets. The emerging economies have a relatively closed and highly concentrated political system with a poor mode of national governance. Consequently, we expect to find that any changes in political risk in these countries will be strongly associated with growth in stock market development indicators and that the economic impact appears to be very large. • The problem of political risk has an important policy implication for growth in these thinly traded markets markets. A great need exists to improve political risk in these emerging countries in order to attract more investment and better allocation of resources through stock markets. More institutional (stock market) reforms are needed to improve accountability, transparency and disclosure, corruption, rule of law, and contract enforceability.