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

3. 1 Emerging markets in the 1900s u u World Trade accounted for huge part of GDP in many countries. u u Equity markets at the turn of the century flourished, many markets established. u u Internet Technology (Railroad) & Worldwide Real Time Communication u u Foreign Investment surged (US$44 Billion in 1913 dollars)

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

5. 2 Data Source: Albert Kimber, Foreign Government Securities, 1919, A. W. Kimber & Company.

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

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

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

9. Cultural Clash between the Modern and Ancient

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

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

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

14. Why Political Risk Matters u u 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. u u 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) u u 3. Self-fulfilling exchange rate crises (see, Banerjee (1992)). u u 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

15. Dependent Variables u u 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) u u equity returns and market volatility: the IFC index. 6

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

17. u u Table 1: eight out of nine financial crises happened within one year before or after the election. u u 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

20. u u 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

22. 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

24. u u 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 u u 2. Equity market returns in dollars.   high current account (surplus)   high capital flow to GDP ratio (lower)   Warning: information lags 11

25. u u 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