Emerging Financial Market 6. Measuring Political Risk

1. Emerging Financial Market 6. Measuring Political Risk Prof. J.P. Mei

2. Emerging markets in the 1900s • World Trade accounted for huge part of GDP in many countries. • Equity markets at the turn of the century flourished, many markets established. • Internet Technology (Railroad) & Worldwide Real Time Communication • Foreign Investment surged (US$44 Billion in 1913 dollars) 1

3. Table 1. The Late 19th Century Trade Boom

4. Data Source: Albert Kimber, Foreign Government Securities, 1919, A. W. Kimber & Company. 2

5. Table 2. Main Creditor and Debtor Countries, 1913Source: United Nations (1949)

6. Major sources of Political Risk in the past • Two Major Exploitations: within and across Countries (Slavery and Child Labor) Caused Strong Resentment. • Communism and the Risk of Nationalization • Colonialism and the Risk of Political Upheaval. (Then superpower was the largest government supported drug dealer in the world) • World WAR I and the Russian Revolution ended the first wave of globalization. • Long-term Return of Emerging markets (not glamorous due to submerged markets)

7. Figure 2: British Sales of Opium to China (Thousand Chests)Source: Mark Borthwick, Pacific Century, Westview Press, 1992

8. Cultural Clash between the Modern and Ancient

9. Measuring Risks • Measurement of political risk • Measuring corruption • Measuring the rule of Law • Political risk measurements can be used in project financing. (discount rates) • Measuring political risks is still an art rather than a science. 2

11. Political Risk Insurance • Eligibility & Coverage • OPIC insurance can cover the following three political risks: currency inconverti-bility, expropriation, political violence. • OPIC insures Business income and assets. • Election of Coverage & Premium Base Rates • Problem: Lack a systematic approach 3

12. Political Uncertainty and Elections Election cycle • a) the time leading up to an election and the time of government transition after the election, and • b) the time after the transition is complete and the next election season starts. • In a democratic system, the election process is a major political event for determining future political course of a country. 4

13. Why Political Risk Matters • 1. The "first generation" currency crisis model represented by Krugman (1979) and Flood and Garber (1984): Strong incentive to engage in inconsistent policies during elections by pursuing expansionary monetary and fiscal policies while holding exchange rates fixed to ensure price stability or other policy objectives. • 2. The "second generation" model of Obstfeld (1994). In such a model, the cost of defending the currency increases when people suspect that the government is leaning towards abandoning the fixed rate. (Banking problems) • 3. Self-fulfilling exchange rate crises (see, Banerjee (1992)). • 4. Contingent investment or "real options": foreign capital flow to Asia from a huge $93 billion inflow in 1996 to a $12 billion net outflow in 1997. 5

14. Dependent Variables • Financial crisis: defined as a sharp shift from inflow to outflow between year t-1 and t • Turkey and Venezuela in 1994, Argentina and Mexico in 1995; and Indonesia, Korea, Malaysia, the Philippines, and Thailand in 1997. • 78 observations (22 x 4 - 10 excluded observations) • equity returns and market volatility: the IFC index. 6

15. Economic and Financial Variables: • the ratio of short-term debt to the foreign exchange reserves • total debt outstanding (long and short term) • the change in the ratio of the financial claims on the private sector relative to GDP over the preceding three years. • current account to GDP ratio • capital flow to GDP ratio • the percentage change in the real exchange rate (RER) in the previous three years. • index of corruption • and Regional Market Contagion Dummy 7

16. Table 1: eight out of nine financial crises happened within one year before or after the election. • Table 2 presents some summary • financial crisis: 23% in political years vs 2% in non-political years • a significant difference in market volatility in political years • high correlation between the political dummy and financial crisis. • negatively correlated with changes in currency value. 8

19. Table 3 presents some summary statistics according to financial crisis. • significantly higher current account deficit, • higher capital inflows, • larger change in bank credit in the past three years, • and higher short-term debt to GDP ratios. • A Probit Analysis of Emerging Market Crises 9

21. Table 4: Probit Analysis • the political dummy turns out to be quite significant even after adjusting • pseudo R-square increase from 0.37 with six independent variables to 0.63 with only four independent variables. • a higher ratio of short-term debt to reserves (liquidity) • a rapid buildup in the claims of the banking sector • a larger current account deficit or capital flows (weakly) • real exchange rate overvaluation: close to zero • corruption not significant • contagion appear to be less important than political risk 10

23. 1. Changes in the currency value (in dollars): • change in bank credit has a very significant negative impact on currency value. • the political dummy a strong negative impact on currency • foreign capital inflows positive • 2. Equity market returns in dollars. • high current account (surplus) • high capital flow to GDP ratio (lower) • Warning: information lags 11

24. 3. Volatility of equity market returns in dollars. • bank credit has a very significant impact • changes in real exchange rates (currency appreciation) • political risk has significant impact • why volatility differs across countries and why volatility shifts through time • Implication for Risk Management • investors and government should increase protection against devaluation and crisis • Political risk premium should adjust according to political risk cycles. 12