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State Ownership, Political Risk, and Asset Prices

State Ownership, Political Risk, and Asset Prices. Andrea Beltratti, Bernardo Bortolotti and Valentina Milella Milan, 26 January 2007. Motivation. The government plays a fundamental role in most countries. It enjoys broad discretionary powers to tax, spend and regulate economic activity.

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State Ownership, Political Risk, and Asset Prices

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  1. State Ownership, Political Risk, and Asset Prices Andrea Beltratti, Bernardo Bortolotti and Valentina Milella Milan, 26 January 2007

  2. Motivation • The government plays a fundamental role in most countries. It enjoys broad discretionary powers to tax, spend and regulate economic activity. • However, the government may also hurt economic agents when new legislation is enacted to cater specific constituencies, when contracts are reneged, and when politicians interfere in the operating activity of firms. • This is Political Risk: the risk that an unexpected policy change affects the returns of a given asset.

  3. Motivation • Large literature on political risk in emerging markets: • Political risk is a priced factor affecting expected returns and international market integration (Erb, Harvey and Viskanta 1996; Diamonte, Liew and Stevens 1996; Bekaert 1995). • Privatization  resolution of political risk excess returns and domestic financial development (Perotti and van Ojien 2001; Perotti and Hiubers 1998). • To our knowledge, no previous study on the financial effects of political risk in developed countries. Nevertheless, political risk matters also in major stock markets and the associated losses may be quite large.

  4. Examples • France: • February 2006: Enel bid on Suez blocked by the French government through the intervention of GdF as white knight. • Italy: • December 2005: Bankitalia blocked the two takeovers attempts by Abn Amro and Bbva over Banca Antonveneta and BNL, respectively. Finally BNL was acquired by French BNP and Abn Amro succeeded. • August 2006: Italian government denies approval to proposed merger between Autostrade-Abertis. • Luxembourg: • January 2006: Luxembourg together with France attempted to block Mittal from a takeover of Arcelor. • Spain: • February 2006: the Spanish government ousts the hostile takeover on Endesa by E.ON via Gas Natural. Nevertheless E.ON succeeds and the deal will be concluded on April 2007 Out of sample: • Venezuela: re-nationalization of the energy sector • USA: The United States rebuffs China over an attempt by the Chinese National Offshore Oil Corporation (CNOOC) to take over Unocal; Dubai Ports World fails in its bid to acquire port operations in the US • Poland:March 2006: Poland demands Unicredit to divest the Polish holdings of German HVB which had already acquired in a merger previously approved by EU regulators.

  5. Research Questions • Likely, a political risk premium associated with government intervention exists also in developed economies. But, • How can we measure it? • How large is it? • The central hypothesis: • Privatized companies (PC) - such as Suez - are particularly sensitive to political risk. Thus a price measure for political risk can be constructed using the returns of PC

  6. Why are PC Sensitive to Political Risk? Privatized Companies • Are typically large firms with a broad clientele. • Provide services of general interest. • Often manage strategic national infrastructures. • Are often used as policy tools to raise fiscal revenues, absorb unemployment, please costumers with affordable tariffs and universal services, and preserve national security in strategic supply. • The pricing of the shares of PC can also be designed to achieve key political objectives, notably re-election.

  7. Theory • The extent to which PC are exposed to political risk depends upon the credibility of the institutional setting. Yet idiosyncratic factors such as the residual state ownership in the firm are key. • By keeping a stake, a market-oriented government can credibly signal its willingness not to interfere in the operating activity in the firm because it would suffer a loss. Then fully privatized firms should be more risky than companies where governments keep a residual stake, and as such they should yield a higher expected return (Perotti,1995).

  8. Research Design • We track the evolution of government control rights (GCR) in firms privatized in EU15 countries from 1977 to Feb-2005. • We study the long-run performance of several portfolios built on different quartiles of GCR for the 1995-2005 period. • We test the effect of residual state ownership and control on expected returns of privatized companies. • Finally, we test the role of political risk in the excess returns of European equity markets.

  9. The Sample of Privatized Companies • European privatized companies through public offers of shares in EU15 equity markets between 1977 and February 2005. • From 1977 to 2005 = 1,177 EU15 privatizations worth US$708bn equal to ½ of global revenues. • EU15 Share Issue Privatizations (SIPs) involved 220 companies and raised 70% of EU15 total privatization value (US$499bn).

  10. Sampling Rules • Political risk spills over in M&A. In case of M&A activity we include in the sample the resulting company (in case of a merger) or the acquiror (in the case of a tender offer or an acquisition). We follow this rule only if the acquiring companies are listed in one or more EU15 stock markets and if the acquiror market capitalization is not more than double of the target company. • Political risk does not last forever. We exclude from the sample the companies turning 5 years after their full privatization (where we define a fully privatized company a former SOE in which the government does not hold any ultimate control right neither in terms of residual stakes, nor golden shares or special powers). • After this screening we end up with a final sample of 190 stocks

  11. Measuring Government Control Rights in PC • We carry out a comprehensive analysis of the structure and evolution of GCR over the 10 years period 1994-2004 (GCR at the end of year t-1 are used to build portfolios for year t) for the 220 privatized companies through public offers of shares. • GCR are measured using the “weakest link concept” as in La Porta et al. (1999), Faccio and Lang (2002), Bortolotti and Faccio (2004). For example if: • Then we posit that the government owns 25% of Firm B.

  12. Measuring GCR in PC • The % is determined by the minimum along the control chain; in case of multiple chains control rights are given by the sum of the minimum values of all control chains. • This methodology allows to take fully into account for pyramidal structures and cross-holdings.

  13. Some Examples: Portugal Telecom Portuguese Government 100% Caixa Geral de Depositos (CGD) Portuguese Government BPI 1.8% 100% 5% 2.1 % 2.5% BES Portugal Telecom 9.7% 4.05% Portugal Telecom The evolution of the government control rights in Portugal Telecom (Portugal) As of the end of 1994 As of the end of 2004 GCR 19% GCR 100%

  14. Some Examples: Distrigaz French State Belgian Government 100% Belgian Government French State ERAP 5.19% 3.21% 100% 100% 100% 100% 3.21% EdF 100% 100% Areva Caisse des Dépôts et Consignations (CDC) 1.17% 78.96% 100% CEA Belgian Municipalities Belgian Municipalities 3.59% 3.1% Cogema Caisse des Dépôts et Consignations (CDC) 100% 36.49% 100% SUEZ 61% 2.2% 3.1% 50% 1.7% 50% Publigaz Publigaz Distrihold Distrihold 3.4% AGF SUEZ Crédit Agricole Société Générale de Belgique 2.6% 100% 20.78% 20.94% 16.62% 16.75% 50.4% 1.6% CNP Assurances 50% SUEZ/TRACTEBEL Tractebel 50% Distrigaz Distrigaz 46.77% 57.53% The evolution of the government control rights in Distrigaz (Belgium) As of the end of 1994 As of the end of 2004 GCR % 39.57 GCR 78.86%

  15. The Evolution of GCR in PC • The evolution of GCR during the 1994-2004 period shows that the privatization process in EU15 has been at least partial and incomplete. • No. of PC increased, mean government ownership and control rights did not decrease.

  16. The Distribution of GCR in PC As of 2004, • ½ of the companies of our sample have the government as influential shareholder with a 30% stake. • ¼ of the firms are under government majority control. • Governments are reluctant to relinquish control over privatized firms.

  17. Forming Portfolios Based on GCR • The data on the evolution of GCR in PC are used to form portfolios capturing a different degree of residual state ownership as a proxy for political risk: • 1st we construct a broad Composite Portfolio (all 190 stocks). • 2nd we form two portfolios using the bottom and top quartiles of the distribution of GCR as breakpoints (GCRQ1 and GCRQ4). • 3rd we calculate monthly value-weighted returns on these portfolios from the end of year t-1 to the end of year t using Datastream series for the 1995-2005 period. Stock prices are expressed in €.

  18. Performance of Portfolios Based on GCR • GCRQ1 €100 in Feb-95 would have grown to €420 in Feb-05 • GCRQ4 €100 in Feb-95 would have grown to €249 in Feb-05

  19. Government Control Rights Portfolios Returns The portfolio based on the lower GCR (GCRQ1) yield raw (R), annualized (AR), and risk-adjusted returns (Sharpe Ratio) higher than all other portfolios, and particularly GCRQ4. GCRQ1 seems also to strongly outperform the Benchmark (DJ TMI)

  20. Government Control Rights Portfolios Returns • We try to explain these differences in stock returns by using the conventional 3-factor Fama and French (1993) model where excess returns are explained by: • Market returns. • Size (proxied by the return of small minus big stock capitalization portfolios, SMB). • Value (given by the high minus low book-to-market portfolios, HML).

  21. The Building Blocks Growth Neutral Value SMALL (BIG) • Starting from the constituents of the EU15 benchmark DJ TMI we constructed SIX PORTFOLIOS: • The median DJ TMI market capitalization is used to form 2 size groups, SMALL (S) and BIG (B). • The bottom 30%, the middle 40%, and the top 30% of book-to-market values are used as breakpoints to split the DJ TMI into 3 value groups, Low (Growth), Medium (Neutral), and High (Value) • From the intersection of the 2 size and the 3 value groups we construct the six building blocks that we define:

  22. The Building Blocks • Finally we used these six portfolios returns to form the SMB and HML factors: • SMB = [average (1,2,3) – average (4,5,6)] • HML = [average (3,6) – average (1,4)]

  23. Size-Value Portfolio Returns • EU data15 are consistent with US data: • controlling for Value  on average Small Portfolios yield higher returns. • controlling for Size  Value Portfolios returns tend to increase, especially in Big Portfolios.

  24. Performance Attribution Regressions and Results • Market, size and value factors matter in explaining GCR portfolio returns. • Composite and GCRQ4 do not outperform. • Interestingly, the estimated Jensen α for GCRQ1 yields 4,44 percent excess returns on a yearly basis. • Thus companies privatized more fully outperform partly privatized companies. • We interpret this abnormal return as a premium for political risk.

  25. Testing Asset Pricing Model in EU15 • The final question: • Is political risk a new common and un-diversifiable risk factor affecting the returns of EU15 markets? • In this direction: • We build 25 size-value portfolios using the constituents of DJ TMI and estimate the CAPM and its multifactor generalizations, including the GCRQ1 portfolio returns as a factor mimicking political risk. • The existence of a political risk beta would suggest that political risk is a new priced factor suitably captured by the returns of (fully) privatized firms.

  26. The 25 Portfolios • The 25 portfolios are built much like the six portfolios: • In each year t-1 we sort DJ TMI stocks by end year market capitalization and book-to-market. • We use DJ TMI breakpoints for size and value to allocate stocks to 5 size-value quintiles. • From the intersection of the size-value quintiles we construct the 25 portfolios. • Finally we calculate value-weighted monthly returns on these portfolios from end year t-1 to the end of year t.

  27. Risk and Return Properties of the 25 Portfolios Excess Returns on 25 Stock Portfolios Formed on Size and Book-to-Market Equity • Size ↑ Returns ↓; Value ↑ Returns ↑

  28. Econometric Tests • We estimate different asset pricing models and test the null of zero intercepts in time-series and cross-section tests: • F test under normality assumptions. • Chi-square tests: “general” and “specific”, with different assumptions on correlation and heteroskedasticity of errors. • Classical Fama-MacBeth (1973) approach, estimating average unconditional risk premia and zero intercepts in cross-section tests.

  29. Empirical Results • We strongly reject the CAPM both in time series and cross-section tests. • The Fama-French model is not rejected in cross-section, but is rejected in time series tests. • Similar results are obtained when factor loadings for sectors are included, with 4 significant sector premium. • When the factor loading for political risk is included, the model is still rejected in time series test. But interestingly, we find an average premium for political risk, while sector premia disappear. • Overall, we find a strong evidence supporting the value premium.

  30. Testing Factor Models

  31. Conclusions • We have linked the evolution of control rights in privatized firms in EU15 to their financial performance • We have found that companies privatized more fully require a significant excess return likely to compensate exposure to political risk. Thus this portfolio returns can be used as price measure for political risk. • The new aggregate risk factor related to political interference seems useful to explain the required returns of European stocks, even if pricing risk in the EU15 remains a challenging task. • Policy implications: curbing political risk by improving the commitment capabilities of the institutional setting may boost market value, and contribute to accomplish full (and sustainable) privatization.

  32. corso Magenta 63 20123 Milano - Italy tel +39 | 02 | 5203.6934 fax +39 | 02 | 5203.6946 web http://www.feem.it

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