Archive for Caribbean Procurement Institute

Sovereign Wealth Funds; A Potential Force from Within For Emerging Nations

Posted in Emerging Markets, Financial Markets, Sovereign Wealth Funds with tags , , , , , , , , , , , , , , , , , , , on May 23, 2009 by evd101

By Erik L. van Dijk

 

Introduction

A lot has been written in recent years about the so-called Sovereign Wealth Funds(SWF’s). Wealth Funds are large pools of money, created by governments or governmental institutions. The Western world is not totally unfamiliar with huge government pools of investments, but normally we associate them with state pension funds. Some wealth funds, like the Norwegian one for instance, do indeed have this form. In other cases the wealth funds resemble long-term investments funds or stabilization funds, used to ensure that one or a few dominant sources of income with volatile prices (e.g. oil and gas) don’t disrupt a country’s national income trends through spectacular ups and downs in GDP caused by large price and / or demand-supply fluctuations.

As so often with new trends, market analysts, journalists and governments have expressed fear that the SWF’s might become too big a force in the market. Are these concentrated portfolios really invested with pure investment motives in mind? Or are strategical and political factors incorporated in the investment philosophy as well? Quite a few pundits have expressed doubts concerning the pure investment activities and skills of SWF’s. They rather stressed the political danger of these institutions.

As if Western goverments do always apply pure investment motives when spending their budgets! SWF’s are extremely large and do invest a substantial percentage of their wealth abroad. Now, if they would have been political entities, investing abroad and going against the rules and regulations of the recipient country is risky. Recipient countries could take nasty countermeasures ranging all the way from court cases and penalties to nationalizations.

SWF’s; a powerful but relatively new phenomenon

In this blog entry we study the pool of existing wealth funds a bit more deeply using the database of the SWF Institute. The database contains some 55 wealth funds from developed and developing countries. The SWF’s from developing economies form the majority (41 out of 55, or 74.5%). This might seem strange, but it is not. When income distributions are relatively unequal, it is not uncommon that governments try to get a piece of the action. And especially the goverments of resource-rich nations have a nice opportunity to do so. However, the structuring of those investment pools into wealth funds implies a professionalization that is rather new. The average year of establishment of the 55 funds in our empirical study was 1995, albeit it that one of the most famous wealth funds – the Kuwait Investment Authority  with USD 202.8 billion under management- was founded in 1953.  And the Foreign Holdings portfolio of the Saudi Arabian Monetary Authority (SAMA)– with USD 431 billion assets under management – was created in 1952. But some of the real big ones aren’t old at all. Here are some of the most remarkable entries since 2005: China Investment Corporation (2007;AUM USD 207 billion), Libyan Investment Authority (2006;AUM USD 65 billion), the Russian National Welfare Fund  aka National Wealth Fund (2008;AUM USD 83.6 billion), and the Investment Corporation of Dubai (2006;AUM USD 82 billion)

The SWFs are an enormous force now and we should not underestimate their impact and influence. Total assets under management for the 55 SWFs in the database continue to show an upward long-term trend and the current level of AUM is USD 3,585 billion. When looking at the amounts needed to repair our financial industry and cope with the credit crisis, this implies that Wealth Funds might be able to play an important role in any recovery plan. It is therefore quite remarkable that Western leaders so far seemed to focus on a strategy based on ‘look to each other, and solve together’. Didn’t we basically make the SWFs in the Middle East and Asia richer by buying their oil and  gas or cheap products, thereby creating a moneyflow from West to East? Only Gordon Brown and Barack Obama seemed to be willing to concentrate efforts on the Middle East (Saudi Arabia and Gulf States). The opening up to Iran in recent periods can also be seen as an important step. Iran is probably one of the most secretive nations as far as its wealth fund(s) are concerned. The Oil Stabilization fund is well-known, but too small to be the whole story. Currently the US and its Western allies on the one hand, and Iran on the other are going through a serious political chess game with probably just one goal. To find some kind of common ground to get Iran back in the league of ”’acceptable” nations. The Roxana Saberi case illustrates how tensions are orchestrated and reduced in a purely political rhythm. In normal situations it would be unheard to see Ahmedinejad suggest things like this to judges within the Iranian judiciary system.

In terms of goals, we see that the bulk of SWFs start of as stabilization fund, and gradually but slowly moved to a role as state investment funds with long-term investment horizon. A next step is the transition into full-fledge pension system, at least with a substantial part of the assets involved. A growing number of nations understand that the creation of a pension system provides countries with a tremendous source of savings and investment potential that can help stabilize the political situation in a country and fight extremist tendencies while at the same time helping to stabilize the economy.

SWF’s; The New Capitalism?

When comparing the SWFs with other large institutional investors, there are some structural differences. One of the most important ones according to us, and that holds especially for the SWFs that are based on energy- and commodity-related wealth, is their ability to concentrate on (ultra) long-term growth. This will enable them to capture higher returns by locking in the higher risk premiums on riskier investments while working with an asset mix that is more tilted towards riskier asset classes. Obviously, with this type of SWFs often being from countries that did not establish themselves as major financial powerhouses yet, we need to place a caveat. The level of knowledge within the SWFs might be a constraint. In recent years we did indeed see some indications of suboptimal asset management in the SWFs. Some tended to link this to strategic motives, but a closer look at the asset allocation, holdings acquired et cetera indicated that this was not the whole story. Lousy ‘picking’ at the bottom-up level has played a far more important role. The sad investment story of Chinese insurer Ping An that bought a stake in Dutch-Belgian financial conglomerate Fortis at about the worst moment possible is indicative. This is not to say that there aren’t any ultra-professional, well-managed SWFs. But the difference in investment expertise is still striking and far bigger than it is within the institutional investor community in Europe or the US.

Now, with their long-term focus, enormous wealth, and huge size compared to the local economy (which automatically implies that the focus has to be to quite a large extent ‘international’) and top-down, hierarchical decision structure SWFs are definitely not pension plans like the ones we know in Western Europe or the US. Their relative lack of transparency concerning decision taking, performance analysis, compliance et cetera further strengthens the case that this is really a new category of investors entering the stage.

Sure, when looking at total assets under management Western institutional investors are – as a group – still far more important. However, also more fragmented with smaller average sizes and with a much larger focus on low risk, fixed income assets. The impact of SWFs on global stock markets will therefore most likely increase tremendously in the years that lie ahead of us. First of all, because the economic growth rates in the nation mix of SWFs are higher than those in nonSWF-dominated economies. Second, most of the traditional Western institutional investors don’t really grow that fast anymore with the inflow of pension premiums more or less offset by payments to pensioners, with demographic trends making it almost impossible that this will really change.

This implies that we need to take a closer look to what could happen in the future when taking these trends into account.

China will win, but energy-related SWF’s should not be underestimated in the next 10-15 years

Although the Asian SWF’s are gaining in importance, led by the Chinese Wealth Funds that benefit from the country’s growth record, the oil-related wealth funds will be a dominant force to reckon with for quite some time to come.

The energy-related wealth funds represent a bit more than half of the group of 55 when we look at the number of funds (31), and in terms of assets under management their total of USD 2259 billion represents 63 percent of total AUMs of the wealth funds.

So, unless the growth rates in China and some other Asian nations reach record highs, with oil prices remaining sluggish, the Middle Eastern SWFs – actually the group that most people fear because of their lack of transparency – will remain a very important category to take into account. We at Lodewijk Meijer believe that it is not just for this reason important to ensure a dialogue with this group of wealth funds. Also when looking at the political situation in the Middle East and the problems with global terrorism, an open and fair communication, trade and investment relationship with the countries in the Middle East will certainly be beneficial in these areas as well. The West should recognize that quite a bit of the tensions are directly related to flawed drawing of country borders in the Middle East by Western occupiers in the past in combination with giving Western oil companies too large a stake vis-a-vis the revenues left for the energy-rich countries itself. Add to that the fact that quite a few nations were or are led by leaders that do not have the support of the population to the same extent as they have Western support and an important part of  the terrorist story is explained.

Development and growth in general have always worked against terrorism. Terrorists thrive in climates with inequality, lack of chances, and poverty. The SWFs and their growth stories will definitely make it less likely that MENA countries themselves – as a group – will witness increased terrorist activity. Skepticists will add that they will have more funds available then to support terrorist activities elsewhere, but we tend to believe that this risk is far more greater when not allowing these nations a dialogue and place within the family world nations, while at the same time helping their SWFs to further professionalize and internationalize their portfolios. This is a win-win situation for all.

SWF’s and the local economy; catalysts for growth….

but local growth can only thrive when economies develop further and governance improves:

The Trinidad Case

SWFs are huge. Often too huge compared to the size of their local economy. They do therefore have to diversify internationally. This implies that their wealth that was often created through Western imports of oil, gas and relatively cheap products will in the end – to quite some extent – flow back to us and other nations via financial market transactions.

That is not to say that SWFs cannot play a fantastic role when developing the local economy of countries. Their potential to be a catalyst of growth is huge. A nice example is the situation in Trinidad and Tobago.In an earlier entry to this blogwe told a bit more about the country, one of the least know oil states in the world. Most people outside the region still believe that the whole Caribbean is about tourism and tropical products, but Trinidad and Tobago is definitely an important exception with attractive growth potential that makes it an interesting Frontier Market.

The country’s Heritage Fund has assets under management of USD 2.9 billion or about 12 percent of GDP. And that percentage will be growing assuming that oil and gas prices will at least stabilize. Trinidad wants to establish itself as a regional financial center and we believe that this strategy could work when undergoing a structured transformation of the economy and upgrading of the financial market system. When taking into account that Cuba will probably be an interesting new entry to CARICOM any time soon (we at Lodewijk Meijer think that it could take approximately 3-5 years for this to happen), that regional financial role could really be of tremendous importance. The ongoing growth in the trust/offshore business in the CARICOM region could also further improve things, with Port-of-Spain then becoming a logical on-shore financial center for the off-shore islands of the region.

When talking to local leaders and international investors, we believe that the opportunities are there.

However, one thing that worries us – and an area where change is needed – is the relatively low country score (3.6 on a scale of 1 to 10 with 10 being the highest) on the Transparency International Corruption Index (CPI). Activities undertaken by institutions like the Caribbean Procurement Institute, Trinidad and Tobago’s chapter of Transparency International and by politicians with large popular support and a willingness to change things could all help. Currently, developments in the ongoing proceedings of the Uff Commission of Enquiry into the Construction Sector of Trinidad and Tobago seem to indicate that – as so often in many nations, even developed ones, – construction and real estate are the areas where lacking corporate governance and fraud have led to a situation in which public funds were misused for personal gain by corrupt politicians/bureaucrats and/or entrepreneurs (e.g. within the construction industry)  and/or lost through incompetency, with a political chess game being played in the background. When analyzing the corruption proceedings, we believe that the nepotists seem to have decided to make former minister of Housing Dr Keith Rowley (one of the most popular politicians in the country, with a tremendous track record as far as new housing activity is concerned while he was in charge of that ministry, and one of the architects of the Vision 2020 report in which the transition into a more diversified economy was first introduced) their scapegoat over a negligble malperforming housing project after he left office. And not just that, too much decision power was and still is not in the hands of ministers in the first place, but is concentrated within UDECOTT;  the Urban Development Corporation of Trinidad that seems to act like a kind of state within the state.

 The Commission will present its final report in September 2009 and we are optimistic that it will unravel a smelly truth about what is a standard nepotism case so often seen in developing economies. Local newspapers help set the stage for a climate in which nepotists are forced into defensive positions. This is a tendency quite often seen in developing nations. When the country develops and corruption fighting grows into a serious countervailing power, the growing independence of the media is not just an important sign of this, but a tremendous catalyst as well. The country’s growth story and transition into a more diversified economy with expanded financial sector will further improve things. Smaller local nepotists will lose out when ‘big finance’ discovers the region. Huge financial institutions will – through the investment opportunities they provide andthrough their larger focus on procurement and ESG strategies (they have too much at stake to be caught in local scandals!)- basically provide the final blow to the nepotists even when the Uff Commission verdict doesn’t already do so in a legal setting.

Along the way the role of the Heritage Fundwill become more important; a) as the largest local investor; and b) as entity attracting the professional skillset of international investors, litigation lawyers, investment bankers, asset managers, investment analysts et cetera. Either directly (to work for the Fund) or indirectly (through provision of services by parties wanting to establish a position for themselves in the country).

This Trinidad example is illustrative for developments in many Emerging economies. And the trends we see developing here have so far shown that in successful growth stories external money and expertise went hand-in-hand with a local willingness to fight corruption from within. And from an investment point of view: it is actually this group of Emerging and Frontier markets where both components are visible, that actually have showed the most attractive return-risk profile.

SWF’s and the international economy; a growing role to play

With total assets under management of USD 3585 billion, it is clear that SWFs can be an important force when leading us out of the current credit crisis. The combined assets of the big Western institutional investors are still far larger, but SWFs are quickly catching up.

We foresee that their role and positive contribution will substantially increase during the next 6 to 12 months, with the beginning of a positive change already under way. Part of the 30+ percent stock market return generated during the first 5 months of 2009 was directly related to SWFs stepping in (finally!) looking for bargains.

Evaluation

SWFs are a relatively new phenomenon. Their large pools of funds are of tremendous importance to the domestic economy and are a great support for the world economic situation as well, because most of the SWFs are too big to concentrate on a home-alone policy. They have to diversify internationally to a larger extent than most other institutional investors a) because the local economy is not big enough; and b) because it is often not diversified enough.

Western nations have often complained that investment behavior by SWFs was to a large extent guided by strategic instead of economic principles. So far evidence in this direction has not been convincing at all. Sure sometimes strategic motives might have player a role, but wasn’t that the same for Western investments in our past?

The attraction that economic development and wealth funds have to international financial instutions that might want to provide services to them will trigger a climate of financial sector dynamics and growth. What could hurt the positive potential effect of this is often a local climate in which nepotism and corruption thrive. Once that threat is neutralized, the upside potential will be tremendous.

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The Value of Virtue

Posted in Behavioral Finance, Emerging Markets, Financial Markets, Risk Management with tags , , , , , , , , , , , , on April 10, 2009 by evd101

By Erik L. van Dijk Introduction They are already working on it since 2002, but it is a fine academic paper on a topic that is getting an increasing amount of attention in recent years: corruption and fraud. Cornell scholars Charles Lee and David Ng studied corruption levels in 44 countries, using the Transparency International database. There have been numerous studies using this and other databases over the last decades, probably starting with work by Anne Krueger (later Chief Economist at the World Bank, together with the IMF and OECD also very active in this area)  in the 1970s. What makes the Lee-Ng study special is according to us at Lodewijk Meijer first of all the translation of country corruption scores into analyses of the impact of corruption at the firm level. By doing so, the authors are capable of answering the question if there is any ‘Value in Virtue’. This is a very important topic, because we see that the literature so far defended two positions. Up until 2003 we have seen various – mostly theoretical and deductive – studies that defended the view that corruption, defined as the misuse of public office for private gain, might actually be a kind of ‘bonus’ system in countries in which salary schemes and other remuneration for talented labour are inefficient. Empirical research presented over the years has indicated that this position is probably totally wrong. Theoretically fine, but the empirical evidence is overwhelming and contrarian. Various studies performed between 1995 (Mauro) and 2006 (Lee and Ng) led to the following conclusions: The Negative Impact of Corruption at the Macro Level, as presented in various academic studies

  1. A higher level of corruption translates into lower domestic investments and economic growth
  2. Higher levels of corruption hinder Foreign Direct Investments
  3. Higher corruption leads to lower tax revenues
  4. More corrupt environments stimulate negligence with respect to operations and maintenance in both firms and government institutions
  5. And point 4 even extends to health care: more corruption leads to higher infant mortality rates
  6. Higher corruption leads to higher student dropout levels in universities and high schools
  7. Higher corruption levels go hand in hand with a larger size of the grey economy, which is of course directly related to point 3

Jain (2007) analyzed what corruption actually is. When stating that corruption is about the misuse of public power for private gain, we basically translate it into an economic act. Why? Well, the cost-benefit analysis of corrupt persons involve three aspects:

  1. Someone must have the discretionary power to take decisions and consider a corrupt or fraudulent act
  2. There must be some kind of economic merit associated with that power
  3. The existing legal system provides a sufficiently low probability of detection and/or low penalty for the corrupt wrongdoing

Although it is clear that the legal part of the anti-corruption policy should play a leading role in fighting these crimes, it is also clear that social, cultural and economic aspects play an important role as well. Reason: in the end, corrupt acts are a cost-benefit decision case in which a probably talented individual or a group of talented individuals undertakes activities that are counterproductive from a macro- and microeconomic point of view. It would therefore be fantastic when it can be proven that economically, corruption destroys value at the micro- and firm level. If that can be shown, the likelihood that a well-defined remuneration system (positive stimulus) can help the negative stimulus derived from the improvements in the legal system will ensure a more effective anti-corruption policy. We are pleased to see that this philosophy of our firm, Lodewijk Meijer, has been translated into action by an Emerging Markets anti-corruption initiative: the CARICOM’s Caribbean Procurement Institute. Lodewijk Meijer managing director Erik van Dijk was appointed facutly member for ESG Finance and Investments. The abbreviation ESG was defined in the United Nations Principles for Responsible Investment, with E standing for Environmental, S for Socially-responsible and G for Governance. The idea is that a good ESG policy will help governments, firms and other economic actors in attracting capital and better conditions while at the same time ensuring better profitability and growth in the long-run at both the macro- and micro-level. In other words: we believe that there is Value in Virtue. With this being the case,  officials with the potential power to be corrupt might – when of course being confronted with a legal environment that makes fraudulous/corrupt freerider behavior too risky (i.e. the probability of getting caught and the negative incentive related to the penalty that follows make it more interesting to go for realization of a positive reward) – concentrate on realization of positive social and economic results. The Agency Theory work by Jensen and Meckling has of course indicated that this optimistic view is indeed only warranted when the legal and regulatory framework is sufficiently corruption-proof. This being said, initiatives like the Caribbean Procurement Institute are of the utmost importance in many countries. The latest ranking list of Transparency International indicates that the bulk of nations in the world still suffers from far too high – and therefore value-reducing – corruption levels. The list of countries which have a reasonable score is limited to about 22 with a score in excess of 7.0 on a scale from 10 (lowest or no corruption perceived by people surveyed) to 1 (highest level). This is approximately 15 percent of the number of nations in the world. So a lot needs to be done. The Transparency International 2008 Corruption Perception Index ranking The top (score in excess of 7.0) The top-22 consists of only two non-developed nations, namely Saint Lucia and Barbados. Both actually part of the CARICOM for which the Caribbean Procurement Institute defines its policy. The other 20 are mainly from Europe (13) with 3 Asian representatives (Singapore, Hong Kong and Japan), 2 from North-America (Canada and the USA) and 2 from Oceania (Australia and New Zealand).  Denmark, New Zealand and Sweden have the highest score (9.3) and my own country, The Netherlands, shows a good score (8.9) as well. The rest of the list The rest of the list is mainly filled with Emerging Markets nations, although there are certain developed nations were corruption levels have remained remarkably high. To some extent low places in the list are directly correlated with flaws in the legal system. But we do have the impression that ‘social’ and ‘cultural’ factors play a role as well, including religious factors. Treisman (2000) has done some interesting research in this area. He found that low corruption levels are positively correlated with the following factors:

  • Protestantism;
  • Former British Colonies;
  • Higher GDP;
  • Common Law versus Civil Law-based legal systems;
  • Higher ratios of imports to GDP (i.e. openness/integration of a country in the world economy);
  • Longer exposure to democracy;
  • Unitary forms of government.

Remarkably, Treisman’s study showed that the following factors are not significant.

  • Relative salaries in the public sector;
  • Degree of political stability in a country;
  • Endowment with natural resources;
  • Degree of state intervention in the economy;
  • Level of ethnical diversity.

The need for a multi-factor approach at the micro level As you can see, the bulk of these analyses is focused on the macro level. However, acts of corruption are undertaken by individuals or groups of individuals at various levels of society with the bulk of course being at the lower levels (simply because of the law of large numbers). Sure, at the lower levels the relative amounts at stake are often smaller or marginal, but added up they have just as much of a disruptive impact on society as the few occasions of big fraud and corruption that catch the attention of the media. We do believe however that it is important that procurement lawyers keep a good balance between the bulk of smaller cases with in the end the largest aggregated impact and the few media cases that catch the public eye. The latter play an important role in showing people that the high level hot shots are not getting away with their fraud. This has an extremely important effect on the cost-benefit analysis at the lower levels. At the lower levels, it is not just corruption that is at stake. Corrupt acts can easily be examples for employees working in firms. The recently published report on fraud by PriceWaterhouseCoopers under some 5400 firms in 40 countries shows the following results:

  • Men are responsible for 85 percent of fraudulous acts. To some extent this is related to their dominance in the labour force, especially in emerging markets, but it is also directly related to what we already indicated in our blog entry on investment styles. Basically, the cost-benefit analysis that is at stake when commiting fraud or corruption is an investment decision. The risk to get caught is probably seen as less of a barrier for men – who normally opt for higher risk strategies – than for women. Machoism in cultures is also important. A men who gets away a few times with fraud and then gets caught might be considered a ‘tough, cool guy’, contrary to the sissy whimp that just listens to his superior. Women are not so sensitive to this kind of reasoning.
  • About 70 percent of fraud cases is commited by men in the age class 35-55. In other words, the age class in which men get a bit more confident concerning their societal status, with their built-up experience giving them the feeling that even after being caught they might find employment elsewhere. Younger men suffer more from machoism, but probably tend to translate that into other acts (harrassment; or fighting in bars in the weekend etc.) than their older gender colleagues.
  • Social control – also in the work place – is important. The PwC study indicates that 68 percent of frauds worked as a loner.
  • Contrary to standard beliefs the main frauds were not temporary workers that switch from one employer to the other quickly. One third of frauds worked 2-5 years for the firm, with the bulk of the others working longer for a specific firm!
  • And just like what we see in the government corruption case, it is definitely not true that it is about peanut crimes at the lower levels only: about 25 percent of fraud cases was directly related to top management, with industries known for their complex valuation and risk management structures like real estate, construction and banking/insurance/investments being well-known for large fraud cases in recent years.

It is impossible to create a corruption- and fraud-free world. Everybody makes his or her own cost-benefit analysis. Moral decay is a reality and so is the deterioration of social control structures. This implies that there is a growing need for strong procurement initiatives and improvements in law, just as much as there is a need for attractive, smart salary and wage structures that reward acts of good-doing. In both areas a lot needs to be done. Recent discussions in the financial industry about excessive greed and horrible bonuses for top managers were just as much indicative of the moral decay and mentality of the people accepting these bonuses as they were of incapable human resource professionals and corporate lawyers helping top management and their controlling bodies (governments, labour unions, board of directors) to create smart bonus structures that award tremendous performance and penalize bad performance. When analyzing the Value of Virtue, it is important to check things at the micro level as well. Firms are still the economic drivers of most developed and developing societies. It would be fantastic if we can prove that firms acting in a more corrupt environment (and therefore probably being direcly or indirectly part of this system) are actually valued lower than their less corrupt counterparts. That is exactly what Lee and Ng tried to achieve in their study. There are a few problems when translating the macro results into micro-level conclusions. First, the available ratings are often at the country level. It is only recently that specialist ESG asset managers have started to use analysts or special bureaus to rank and rate individual firms. And unfortunately – due to a lack of data and maybe even interest (after all Emerging Markets investments are still just 5-10 percent of the institutional equity portfolios of institutional investors in developed nations) – they have started this trend in the developed nations. I.e. in the group of nations where the need for firm-level analysis is probably a bit smaller due to good control and legal systems. This is another reason why Lodewijk Meijer supported the Caribbean Procurement Institute initiative. It is a) from a mainly Emerging Markets region (CARICOM) and b) a region that has shown the willingness to act; with c) the presence of 2 CARICOM nations (Saint Lucia and Barbados) in the world top-22 indicating that it is not just willingness, but also actual success that can be shown. When analyzing the valuation effect of corruption at the firm level, we have to deal with a few problems. Firm valuation is dependent on a large number of variables, not just corruption. We do therefore have to create multi-factor models that unravel the valuation of individual firms in various nations while at the same time ensuring that differences in industry distribution between countries are taken into account. Lee and Ng regressed two valuation variables, the Price / Book ratio in which the market price of a stock is divided by the book value of common equity, and Tobin’s Q, defined as the market value of debt plus equity divided by the book value of debt plus equity, on a set of firm and country variables. The firm variables that they looked at where:

  • Return on Equity (for the P/B analysis)
  • Return on Assets (for the Tobin’s Q analysis)
  • Profit Margin (net)
  • Research and Development Expense / Sales
  • Dividend Payout
  • Beta (systemic risk factor measuring the firm’s stock market return sensitivity to changes in the MSCI World index)
  • Currency Beta (measuring the sensitivity of the stock market return of the firm to changes in the value of the US Dollar vis-a-vis a basked of major currencies)
  • Earnings growth (5 years)
  • Credit Rating of the firm from Institutional Investor Magazine

At the country level, the researchers looked at:

  • Country level average Return on Equity (for the P/B regression)
  • Country level average Return on Assets (for the Tobin’s Q regression)
  • Inflation
  • GDP growth
  • And of course, the Transparency International Corruption Perception Index

For a 10 year research period (1994-2003) the researchers were left with almost 60,000 valid observations. More than enough for a good statistical analysis. If Virtue would add Value, the result should be that in both the P/B and Tobin’s Q regressions higher levels of corruption would translate into lower valuations. I.e. Corruption should have a negative and significant sign in the regressions. This was indeed the case. The Cornell scholars found that – ceteris paribus (all other things being equal) – firms in the high corruption tertile had a 15-20 percent lower valuation than firms in the low corruption tertile. There was not much difference when looking at P/B compared to Tobin’s Q, with the latter being a firm-level analysis and the former looking more at the equity level. Value in Virtue: where does the value loss for firms in a corrupt system come from? When looking at the theoretical discount models, value loss could come from reduction in expected future cash flow and dividend levels, reduction in earnings growth or increases in the required rate of return that a firm would have to offer its shareholders and debt providers. Common belief was that the increase in the required rate of return is the dominant factor. However, Ng and Lee show that this is not true. In a corrupt system firms suffer mainly because the expected future cash flow levels will be lower. Partly because of the corruption (extraction of cash via bribes etc.) itself and partly because of loosing customers and/or translation of the corrupt climate into direct internal fraud (people at all levels in society start to believe that if greed and immoral theft is the standard, then let’s do it ourselves as well). Especially international clients and/or investors might be very weary to do business. The tremendous growth of ESG Investing in recent years is indicative of this trend. Both employers and employees (via their labour unions) on the one hand, and the government on the other, stimulate this trend. Good examples are the large Swedish state pension plans AP1 to AP7, who have a combined ESG investment policy, and the Dutch mega investor ABP, one of the largest pension plans in the world. However, ESG is growing but not so big yet as to guide investment decisions of institutional investors completely. But it is indicative that even private investors are getting more enthousiastic about the idea. Not surprisingly as our analysis shows. There is Value in Virtue for long term investors and firms following an ESG policy. We believe that this can be of special importance in Emerging Markets. It will increase value and enable firms and countries following a good ESG policy to attract more foreign capital which in turn can lead to further growth. CLICK THE LINK BELOW FOR THE FULL NG-LEE STUDY corruption-virtue